Yield Curve Flashes Near-Recession, Maybe

"Predicting recessions involves a lot of correlation and not a lot of causation.

What many believe is the best predictor is from the Treasury market, and it is back in focus: an inverted yield curve, or higher yields on short-dated bonds than on long-dated bonds.

The correlation is what convinces many that we are close to a flashing warning sign.

The yield curve has inverted before every recession, and one widely used version is close to inverting again.

The gap between the two-year yield and the 10-year yield fell below 0.2 percentage point in the past week for the first time since the 2020 recession.

There are issues with the correlation I will come back to shortly, but first think about the causation. Economic history has some pretty compelling explanations for many recessions, and it strains credulity to think the yield curve predicted at least two of them in advance.

The 1973-1974 recession was clearly caused by the Arab oil embargo that began in October 1973, after the U.S. gave aid to Israel to defend itself. The yield curve had inverted in March that year (data on two-year Treasurys don't go back that far, but one-year yields rose above the 10-year), supposedly predicting a recession. Treasury traders hadn't predicted the war or embargo, however, so how could they have predicted the recession? The brief 2020 recession was equally clearly caused by the pandemic, and we all remember why. The yield curve had inverted in 2019, but even the most extreme Covid-19 conspiracy theorist would struggle to believe that bond traders had advance warning that Covid-19 was on the way.

The current yield-curve focus is on the U.S., but Europe, and especially Russian-energy-reliant Germany, is regarded by economists as more at risk of an imminent recession. If the yield curve is a good indicator, Germany will be fine, since the curve has steepened, not inverted, since the Ukraine invasion.

Whisper it quietly, but maybe the yield curve isn't quite as useful as many think as a recession alert.

Here we come back to the correlation question. It is true that before every recession the curve inverted. But a warning that comes between a year and three years before a recession -- even ignoring the 1965 and 1998 false alarms -- is hard for an investor to act on. It is hard to stick to bearish convictions if stocks keep going up for years, and you are missing out.

After the yield curve inverted in 1989, for example, stocks rose more than a third before the recession started in mid-1990. Similarly, those who switched from stocks to safer assets when the curve inverted at the end of 2005 had to endure a rise of more than a quarter in the S&P 500 and wait two years before the bet worked out.

Rather than warn of recession, an inverted yield curve is better read as a sign to investors that the economy is late in its cycle. That is, the Fed is tightening policy to slow the economy. The deeper the inversion of the curve, the closer the cycle is to its end, and, barring a soft landing, recession.

Yield-curve pioneer Prof. Campbell Harvey of Duke University's Fuqua School of Business prefers to compare the three-month yield to the 10-year. The Federal Reserve Bank of New York likes this approach so much it built a probability model from it based on the idea that the more inverted the curve, the more likely recession is. At the moment, the answer is: It isn't very likely at all. In February it put the chance of a recession in the next 12 months at 6%.

Frustratingly for those trying to drum up recession concerns, using the three-month yield curve is actually further away from inversion now than it was before the Russian operation to protect Donbas, as the 10-year yield has risen more than the shortest yields. The Fed might cause a recession by jacking up rates too far, too fast -- but so far it has only raised rates once, so this remains an issue for 2023 or 2024, not today.

The response of doom-mongers -- of whom I am usually one! -- is to say that the yield-curve warning is often dismissed: This time is always different. Deutsche Bank strategist Jim Reid highlights former Fed Chairman Ben Bernanke's March 2006 comments explaining why it would be fine that time and Chairman Jerome Powell joined in the dismissals on Monday. He pointed to Fed research that concluded that what really matters is the gap between three-month yields now and the implied three-month yield in 18 months' time. If traders are betting on lots of rate cuts in the next 18 months, they are expecting a recession. Right now, they aren't.

The yield curve will be talked about a lot more as the increasingly hawkish Fed means it is likely to be flatter and inverted on more measures over the next couple of years. The correlation doesn't mechanically mean recession is on the way and especially not soon.

 

But investors should be closely watching the causation. The higher rates go, the more likely the Fed overdoes it and slows the economy too much." [1]

 

1. Streetwise: Yield Curve Flashes Near-Recession, Maybe
Mackintosh, James.
Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 25 Mar 2022: B.1.