Steep Yield Curve Revisited
We discussed the steepness of the yield curve one year ago in the inaugural Weekly Insight. The point was that, contrary to popular belief, a steep yield curve doesn’t always mean that a robust economic recovery is in store, especially when banks need to repair their balance sheets. Today’s yield curve remains steep, but we continue to suggest that bank lending will contract and that the economy and stock market are likely to do so as well. The main reason that traditional interpretations of the yield curve (think Federal Reserve), that put the probability of a recession near zero, will be off the mark is that, as last week's charts showed, this is an unfolding depression, not an ordinary recession.
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Our first chart comes from the Federal Reserve Bank of New York, which shows the current spread between the 3-month Treasury bill and the 10-year Treasury note. Our second chart shows the Fed’s “Probability of Recession” based on the spread. To calculate the probability of recession in the next two to six quarters, the Fed looked at data from 1960-1995 and concluded that any spread larger than 1.21% would mean less than a 5% chance of recession. With the 3-month T-bill at .08% and the 10-year note at 3.31%, today’s spread is a giant 3.23%. So, according to the Fed’s model, there is only a minuscule probability of recession in the next 18 months. And it would be right in most situations.
However, there is a problem with the Fed’s data set and, therefore, with its conclusion. The Fed’s selected time frame does not include any deflationary periods, which makes it a less-than-robust model (that is, one that won't work in all economic environments). In fact, it’s reminiscent of the models used to price mortgage-backed securities. You know, the ones that didn’t bother to consider what might happen if house prices fell. So, if the inputs fail to include all scenarios, when an unexpected scenario hits, the conclusions are likely to be as wrong as AAA subprime ratings.
The concept that a steep yield curve will produce economic expansion has a glaring strike against it too. The Japanese have experienced rolling recessions and deflation for almost two decades despite having a positively sloped yield curve from 1992 through today. For the entire 18 years, the Fed’s spread model would have given less than a 25% chance of recession, and most of the time less than 5%. So, it’s safe to assume that the Fed’s model is unlikely to alert investors to a deflationary depression.
The Fed’s yield curve model represents the old saying, “When interest rates are low, stocks will grow.” Under normal circumstances, this adage might have some validity. But according to our larger Elliott wave count, times are about to be anything but normal.
Disclosure: No positions
