Global Crises, Central Bank Responses, and the Inversion of the Yield Curve

Mustafa Yagci

26 Mar, 2023

Introduction

The global economy and the international financial system have been rattled by crises of varying sources since the start of the new millennium – from the bursting of the dot-com bubble in the early 2000s to the 2007-2009 global financial crisis. Over the past couple of years, the effects of the devastating COVID-19 pandemic, followed by the East European crisis, have continued to make waves through global markets.

Beginning in 2020, the global economy was challenged by the COVID-19 health crisis, which translated to both supply and demand shocks amid mobility restrictions. As a result, many countries faced recession, unemployment rates escalated, and extreme poverty intensified. With the escalation of the situation in East Europe, recovery efforts from the pandemic were hampered and global commodity markets witnessed a surge in prices. As inflation accelerated in many countries, many central banks implemented monetary tightening as a policy response.

Amid contractionary monetary policies to control inflation, the interlinkage between the financial markets and the real economy has intensified. Central bank policies have been decisive in shaping the trajectory of the financial markets, which also affects the decisions of stakeholders in the real economy. The extent to which central bank policies are affecting financial markets and the real economy shall be examined amid recent developments, such as the recent bank failures in the United States.  

Central Bank Responses to Global Crises

Central banks have become the key actors in response to global crises. In addition to the balance sheet expansion via quantitative easing policies, central banks in advanced economies can lower interest rates to near zero levels to lessen the impact of the financial crisis and stimulate economic growth. These measures were considered unconventional because they diverge from routine central bank practices before the global financial crisis.

At the onset of the COVID-19 pandemic, central banks lowered interest rates to support economic recovery efforts. As the world recovered, there was a recent surge in inflation, prompting central banks in advanced economies to increase interest rates to tame inflation. Figure 1 illustrates how major central banks such as the Bank of England (BoE), European Central Bank (ECB), and Federal Reserve (Fed) of the United States have reduced the interest rates in the aftermath of the global financial crisis and started to increase interest rates recently. With the rising interest rates in advanced economies, risk premiums are rising around the world. This creates significant pressures on currency depreciation and sovereign debt sustainability in emerging and developing countries.

Figure 2. Central Bank Interest Rates (%)

One of the implications of the monetary policy shifts is the changes in bond yields. Since monetary policy sets the course of the interest rates, and these rates characterize the yield of government treasury securities defining the risk-free rate of return, monetary policy ultimately affects the demand for financial securities, including bonds.

All things held constant, when interest rates fall in an expansionary monetary policy environment, bond prices are expected to rise, and bond yields fall. When bond yields fall, borrowing costs for companies and the government become lower, leading to increased spending and economic expansion. Meanwhile, when interest rates rise in a contractionary monetary policy environment, bond prices are expected to fall, and bond yields rise ceteris paribus, raising the borrowing costs for the private sector and the government. Looking at the relationship between the benchmark 10-year US treasury bond yield and other yields in the financial markets, we can observe that yields of other securities follow the general movement of the US treasury bonds.

Inversion of the Yield Curve

Current yields in government bonds are relatively lower, coming from an expansionary monetary policy at the beginning of the pandemic. However, as many advanced economies are currently adopting a contractionary monetary policy to combat accelerating inflation, the expectations of further interest rate hikes result in a mismatch in the yields of short and long-term bonds. Normally, long-term bonds have higher yields than short-term bonds in order to reward investors for taking on the extra risk of longer-term investments. However, present data suggest that the reverse is happening due to the current state of central bank monetary policy.

A “yield curve inversion” occurs when short-term bonds have higher yields than longer-term bonds. Figure 2 highlights the starting of yield curve inversion during the summer of 2022 and the sustained yield curve inversion since October 2022 in the US, as the yields of 10-year and 30-year bonds enter a declining trend starting from June. On the other hand, the yields of three-month, six-month, and one-year bonds start to increase relative to the yields of 10-year and 30-year bonds. The margin between the yields of short vs long-term bonds start to increase in November 2022 and this margin is higher since then. In other words, investors prefer short-term bonds with much higher yields compared to long-term bonds with lower yields.

Figure 2. Yield Curve Inversions in the US

The recent yield curve inversion in the US can be interpreted as reflecting the expectations of investors of sustained Fed interest rate hikes because of the surging inflation. This might result in an economic slowdown in the medium to long term because monetary policy decisions affect the economy with a lag. In fact, some literature suggests that sustained yield curve inversions are signs of an upcoming recession. Over the last few decades, on average 20 months elapse between the initial yield curve inversion and the beginning of a recession in the US. For instance, it took 16 months from the yield curve inversion in August 1978 to the beginning of a recession. On the other hand, another recession started in the US 33 months after the yield curve inversion in June 1998 (Figure 3).

Figure 3. Months Elapsed Between the Initial Yield Curve Inversion and the Beginning of a Recession in the United States

Yield curve inversion is not specific to the US – many countries face them occasionally. In China, for instance, there is a saving yield curve inversion since China’s top four state lenders started setting the interest rate for three-year deposits up to 40 basis points higher than those for five-year deposits. Expectations of an economic slowdown in China combined with higher rates for short-term savings led to a surge in bank deposits.

Implications for Emerging and Developing Countries

Most emerging and developing countries do not have mature capital markets, and their sources of financing are limited. With the increasing need for external sources of financing, policies adopted by advanced economies have spillover effects in price-taking emerging and developing countries. Accordingly, rising interest rates in advanced economies result in higher risk premiums around the world. This creates significant pressures on currency depreciation and sovereign debt sustainability in emerging and developing countries. On the contrary, relatively lower long-term bond yields in advanced economies may help emerging and developing countries attract international investors to fulfill their external financing needs, by offering relatively higher long-term yields in government bonds. Albeit this is not a given and must be coupled with a suitable environment for investment.

Recent bank failures in the United States exacerbate the risks of financial contagion in emerging and developing countries. Emerging and developing economies must strive for agility in facing uncertainty and observe signals of a downturn in advanced economies. With interconnected global financial markets, there is a risk of contagion from advanced economies to emerging and developing countries. As such, emerging and developing countries need to ensure that their fiscal and monetary policies are aligned to weather the global recession expectations and volatility in financial markets. Sovereign debt sustainability and financing mechanisms that support the real economy, productivity, and employment need to be prioritized to support resilience.

The relationship between yield curve inversion and recessionary periods is not causal. However, it warns against self-fulfilling expectations, which warrants the need for a more stable financial market. Volatility in the international financial markets is mainly short-term oriented, profit-driven, and a result of the speculative behavior of investors around the world.

Islamic finance principles can foster stability in the financial markets and can provide guidance for long-term-oriented and productivity-driven financial markets that support the real economy. There is a large room in emerging and developing economies’ financial markets for Islamic finance tools and mechanisms.

---