As the US Treasury yield curve collapsed over the last year, various Fed speakers have promulgated the “it’s probably nothing” or “it’s different this time” narrative to divert attention away from the curve’s almost-perfect record of predicting US economic recessions.
Even US Macro data has started to disappoint (and stocks briefly caught down to it)…
So, it is fascinating that none other than Janet Yellen’s old haunt – The San Francisco Fed – has issued a report warning about the flattening of the yield curve…
“[it] is a strikingly accurate predictor of future economic activity.
Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve.
Furthermore, a negative term spread was always followed by an economic slowdown and, except for one time, by a recession.”
Furthermore, as the two Fed authors explain below, the recent decline in the Treasury curve is sending recession probabilities notably higher…
The predictive power of the term spread is immediately evident from Figure 1, which shows the term spread calculated as the difference between ten-year and one-year Treasury yields from January 1955 to February 2018, together with shaded areas for officially designated recessions.
Every recession over this period was preceded by an inversion of the yield curve, that is, an episode with a negative term spread. A simple rule of thumb that predicts a recession within two years when the term spread is negative has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession. The delay between the term spread turning negative and the beginning of a recession has ranged between 6 and 24 months.
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The central feature of the business cycle is that expansions are at some point followed by recessions. Long-term rates reflect expectations of future economic conditions and, while they move up with short-term rates during the early part of an expansion, they tend to stop doing so once investors’ economic outlook becomes increasingly pessimistic. A flatter yield curve also makes it less profitable for banks to borrow short term and lend long term, which may dampen loan supply and tighten credit conditions. .
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The key question is which threshold to choose; in other words, how far does the term spread need to decline so that a forecaster should predict a future recession? Analyzing the number of false positives and false negatives for each possible threshold suggests that the best trade-off is accomplished for a threshold very close to zero. There appears to be something special about a negative term spread and yield curve inversions, both for predicting recessions and, according to additional analysis, for predicting output growth.
The implication is that a negative term spread is much more worrisome for the economic outlook than a low but positive term spread.
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A number of observers have suggested that a low or even negative term spread may be less of a reason to worry than usual, arguing that historical experiences do not necessarily apply to the current situation; but Michael Bauer and Thomas Mertens also add that “it’s not different this time“…
“While the current environment is somewhat special – with low interest rates and risk premiums – the power of the term spread to predict economic slowdowns appears intact”.
An extensive analysis of various models leads us to conclude that the term spread is by far the most reliable predictor of recessions, and its predictive power is largely unaffected by including additional variables.
Bauer and Mertens conclude by crushing The Fed’s narrative:
Forecasting future economic developments is a tricky business, but the term spread has a strikingly accurate record for forecasting recessions.
Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession. While the current environment appears unique compared with recent economic history, statistical evidence suggests that the signal in the term spread is not diminished.
These findings indicate concerns about the scenario of an inverting yield curve.
Any forecasts that include such a scenario as the most likely outcome carry the risk that an economic slowdown might follow soon thereafter.
So who do you believe? The Fed’s researchers or The Fed’s talking heads?
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