The yield curve referred to is the series of interest rates on government debt of differing maturities (from 1 month to 30 years). The overwhelming majority of the time, the longer a debt takes to mature, the higher the interest rate will be on that debt. This makes sense from a lender’s perspective; more can go wrong over a longer time-frame, so more interest is needed to compensate for that additional risk.
That’s why an inverted yield curve, when short term debt yields more than long term debt, is viewed as such an economic omen by economists, as it implies that the market as a whole sees more risk to the economy immediately than in the distant future.
And historically that fear has been correct, with recessions beginning typically 1 year following an inversion of the yield curve. In May, the spread between the 10-year and 3-month Treasury bills inverted, and as you can see in the chart below, those inversions are usually followed by recession (which are shaded in grey). The past seven recessions have been preceded by a yield curve inversion.
While the yield curve’s predictive power has been 100% for the last seven recessions, a sample size of seven isn’t exactly much to work with. Just like a knowledgeable gambler is aware that past results are no predictor of the future, the same holds true today.
Not only is the past no guarantee of future results, this time the economy is in a drastically different state during our inversion.
According to Forbes:
Claudia Sahm of the Federal Reserve has detailed a novel way to both forecast recessions and make them less severe. She details a sound metric for tracking recessions early; it’s to look for a +0.5% rise in the unemployment rate relative to the unemployment rate’s past 12-month low. This metric has called each of the seven recessions back to 1970, never getting it wrong over that period.
That’s a good success rate, and comparable with the inverted yield curve.
Unemployment rising tends to coincide with the very start of a recession. It’s a fairly early signal, but it tends to be triggered 1-4 months after the recession begins looking back over history. So essentially, given that the current 12-month low for unemployment is 3.6%, if, theoretically if we saw a 4.1% unemployment rate at some point within the next 12 months, then it’s reasonable to assume on Sahm’s metric that would be in a recession.
So unless unemployment were to rise to 4.1% over the next year, there’s no reason to panic.
And that’s not all. The yield curve may have inverted not because of actual economic fears, but because of the Federal Reserve.
The Federal Reserve’s balance sheet now composes roughly 20% of GDP, but was only around 5% of GDP at the time of the past financial crisis. Most of the Fed’s holdings comprise of long term bonds and mortgage-backed securities. As one analyst noted:
According to some estimates, for every 10% of GDP of bond purchases, the 10-year treasury yield fell by anywhere from 0.15% to 2.4%.
Since late 2017, the Fed has been cutting down its balance sheet in a normalization process that should end in the coming months. However, this process has been done by mostly letting short- and medium-term bonds to expire without repurchasing new ones. As a result, the changes in the size and maturity of the Fed’s balance sheet may have also contributed to the fall in long-term term premiums and, indirectly, the flattening of the yield curve.
Additionally, as America’s national debt increases a larger percentage of our debt has been held by foreign countries, and that too may have flattened the yield curve.
While it may be true that the yield curve’s inversion has historically predicted a recession, the fact that are external factors causing it this time means this time, it may be different.
Currently, the betting odds on a recession occurring during Trump’s first term has been cut in half since January, and is among the lowest it’s been during any point of his Presidency. Meanwhile, nearly 100% of corporations polled by CNBC say they don’t expect a recession this year.