The Yield Curve As Recession Predictor: Should We Worry Today?

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by: Bill Conerly

The yield curve has proved to be a valuable indicator of future recessions. Some economists are getting nervous right now, as signals are flashing yellow -not quite red, but certainly not green. However, the yield curve is only indicative of a recession. It is neither definitive nor causal.

The yield curve is a chart showing the interest rate paid on bonds of different maturities. The accompanying chart shows two yield curves. The curve labeled "typical" reflects interest rates in June 2017. Spreads between short-term rates and long-term rates were near their long-term averages. The "inverted" curve - in which short-term interest rates are higher than long-term rates - is from November 2006, 14 months before the 2008 recession began.

As a forecasting tool, the difference between long-term and short-term interest rates is pretty good. The second chart shows the spread between 10-year U.S. Treasuries and 2-year Treasuries over a long time period. Recessions are shaded, indicating that low or negative spreads do a good job of predicting upcoming recessions.

Note that the spread gave five good signals of recession, plus a couple of other indications that turned out not to be recessions. Also note that we've only had five recessions in the past 40 years, so we're looking at a pretty small sample.

Why would the yield curve predict a recession? Two simple explanations come to mind: Higher short-term interest rates lead to recession, or lower long-term interest rates lead to recession. Or perhaps some combination of the two leads to recession.

The effect of high short-term rates makes sense. When the Federal Reserve wants to slow economic growth to prevent inflation, it pushes up short-term interest rates. Spending declines in the interest-sensitive parts of the economy: business capital spending, residential development, and consumer durables (especially automobiles).

It seems paradoxical, though, for low long-term interest rates to presage recession. Low interest rates certainly would not cause economic weakness, but they might result from economic weakness. Long-term rates are much less driven by Fed policy than short-term rates. They reflect supply of savings and demand for credit, with a substantial global influence. When the economy is weak (in the U.S. and around the world), demand for credit falls and savings increases. The result of the weak economy is low long-term interest rates.

Therefore it makes perfect sense that an inverted yield curve would indicate that a recession is coming soon.

Unfortunately, no long-term indicator perfectly predicts recessions. The spread between ten-year and two-year Treasuries is only available back to 1976, but the spread between the ten-year and one-year can be examined back to 1953. It, too, does well, but with a couple of false alarms. The longer time period includes 10 recessions, which is still a small sample.

Historically, the magnitude of yield curve inversions doesn't correlate with the magnitude of recessions. The negative spread between the ten-year and the two-year Treasuries was larger in 2000 than in 2007, though the later recession was far worse than the earlier recession.

Keep in mind, also, that the economy is continually evolving in ways that may change the reliability of any signal. For example, globalization has increased the connection between capital markets in the U.S. and other countries. Foreign trade has similarly increased. Within the U.S., the shift toward services continues, along with the aging population, rising productivity, and the number of stupid cell phone apps. Will any of these developments change the usefulness of the yield curve as a predictive tool? I'm not sure. Maybe Candy Crush.

The yield curve is not currently forecasting recession. However, we are in the caution zone. Continued Federal Reserve tightening, along with soft credit demand, could indicate a recession in the next year or two. All organizations, including businesses, non-profits and government agencies, should develop contingency plans for recession, even though a downturn is not currently the best forecast.