An Inverted Yield Curve, Economic Uncertainty Ahead, and the ARM Industry

On March 22, 2019, the 10-year/3-month U.S. Treasury yield spread – i.e., the 10-year Treasury note yield minus the 3-month Treasury bill yield – fell below zero for the first time since August 27, 2007. Specifically, the yield on the 10-year note (2.44 percent) dipped below the yield on the 3-month bill (2.46 percent), resulting in a negative spread (-.02 percentage points). This indicates that the yield curve – a comparison of bond yield rates across various maturities that typically illustrates a positive relationship between maturity term length and yield total – is inverted and thus expresses a negative relationship instead. Though the yield curve may be based on a variety of different spreads, such as the 5-year/3-month and 10-year/2-year (the official Department of the Treasury yield curve compares 12 separate Treasury bond yields, for example), the 10-year/3-month curve is the most noteworthy because its inversion is one of the most reliable recession indicators available. According to data from the National Bureau of Economic Research, the 10 year/3 month yield curve inverted before each of the last seven recessions, including the 2000 Dot-Com crash and Great Recession. Should a recession follow the latest inversion of the yield curve, the accounts receivable management (ARM) industry could see collection opportunities rise as delinquencies increase and demand for outsourced recovery services follows suit. However, these opportunities may be tempered by a drop in overall borrowing as consumer and business spending slows.

Campbell R. Harvey, currently a professor of finance at Duke University, first advanced the idea that yield curve inversions were useful for predicting recessions in his 1986 PhD dissertation presented to the University of Chicago. Specifically, Professor Harvey observed that each of the four recessions that occurred between 1970 and 1982 were preceded 12 to 18 months prior by an inversion of the 10-year/3-month yield curve. His research relied on only four data points, raising concerns at the time that his results may have arisen from coincidence. Since then, however, the inverted yield curve has accurately signaled the last three recessions.

The graph above illustrates the 10-Year/3-Month yield spread since 1953. Beginning with the recession of 1970, each of the last 7 U.S recessions closely followed an inversion of the yield curve as illustrated by the spread dropping below zero.

Yield curve inversions generally signal that investors believe the Federal Reserve (Fed) will cut rates in response to economic weakness. In other words, there is current consensus that the short-term yield listed today will not be sustained over the full 10 years. Typically, investors expect a lower return, or yield, when their capital is held up for shorter lengths of time. Alternatively, they demand higher gains for long-term investments. The difference in yields reflects the extra compensation that investors require to devote in Treasuries for an extended period. This is due to the time value of money principle, which holds that any sum of money earned today is more valuable than an identical amount earned in the future due to the former’s earnings potential. Because of interest payments or capital appreciation, money is worth more the sooner it is received.

Yield rates also reflect the current and expected future rates of inflation. This is because inflation reduces the value of bonds’ future cash flows – i.e., the remaining interest payments and the principal amount to be returned upon maturation. When higher inflation is expected, yields should rise across the board as investors demand higher returns to compensate for risk that future payouts will be devalued. The current state of the yield curve suggests that investors expect the opposite.

Though the Fed decided to hold interest rates steady in its recent June meeting, Chairman Jerome Powell – nominated in 2017 by President Trump – presented a dovish outlook on the rest of the fiscal year, mentioning that 8 members of the committee suggested potential interest rate cuts while a number of others saw strengthened cases for it. This suggests that the Fed expects less inflation and greater economic uncertainty in the future, driven by the current trade war with China and the European Union, a messy Brexit, and slowing global economic growth, among other things.

Yield curve inversions may signal other potential trends in the economy as well. They imply, for example, that short-term interest rates have risen above long-run rates. When this occurs, businesses require more capital to expand operations, leading to lower investment levels. Concurrently, consumers accumulate less debt, which translates to less spending. Both of these forces intertwine to reduce aggregate demand, thereby slowing general economic activity.

If a recession were to occur in the next 12 to 18 months, as indicated by the inverted yield curve, it would present mixed results for the ARM industry. On one hand, consumers are more likely to miss payments in a rougher economic environment. As shown in the graph below, delinquency rates spiked after each of the last three recessions. Higher delinquency rates positively impact the ARM industry because they lead to greater collection opportunities. On the other hand, however, during periods of economic contraction, consumers and businesses spend less, consequently lowering borrowing levels and potentially limiting collection opportunities as well. Moreover, recessions may create an environment in which account placements become limited in credit grantor sectors that are negatively affected by the downturn – as was the case for financial services during the Great Recession – and the ability to collect on delinquent accounts is more difficult as consumers’ ability to pay falls. Thus, while delinquency rates may rise, the ability of the ARM industry to collect on said debt may become more difficult, and the accumulation of debt may slow as the overall credit market shrinks. Together, these events could create negative operating conditions for the ARM industry.

As of this writing, the yield curve has been inverted for nearly two months, signaling that a recession may be on the horizon. It is not an absolute inevitability, though; depending on global changes – e.g., the Fed’s monetary policy actions and whether the U.S. and China can find a way to conclusively end their trade war – the longest economic expansion ever may extend even longer than expected. That said, ARM companies should prepare for a downturn that may be less than two years away.

For more information regarding the effect of recessions and other economic factors pertaining to the ARM industry, please see Kaulkin Ginsberg’s Accounts Receivable Management Industry: An Industry Poised for Growth. Contact hq@kaulkin.com to purchase a copy.

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