Would The 'Infallible' Message Of The Yield Curve Please Stand Up? A Comment On The Conundrum Of Forecasting

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by: New Deal Democrat
Summary

The yield curve is supposedly an infallible indicator.

But what are we to make of a situation where one portion inverts, while another portion resolutely does not invert?

The paradoxical situation today demonstrates the conundrum of forecasting: that once a leading indicator is nearly universally known, if fails to function as before.

Everyone knows the message of the yield curve, right? An inverted yield curve is an absolutely reliable indicator that a recession is coming in about 12 to 24 months. A positively sloped yield curve means that no recession is on the horizon.

So riddle me this: what does it mean when one relatively small portion of the yield curve inverts, and stays inverted, while another part steadfastly refuses to invert?

In other words, we seem to have two equally infallible but contradictory signals.

Let’s go to the graphs. Here’s the 5 year minus 2 year yield (blue) vs. the 10 year minus 2 year yield (red). I’m only showing the last 12 years so that the current situation, where the former has remained inverted for the last month and a half, while the latter has been relentlessly positive, shows up:

The former says “recession.” The latter says “no recession.” If the 10 year minus 2 year continues to remain positively sloped, which is correct? Either one or the other is failing in its supposedly infallible signal.

Ironically, one of the reasons for this conundrum is almost certainly the fact that, after 50 years of history, “everyone knows” that an inverted yield curve means a recession is coming.

Why?

Historically the stock market has peaked between 3 to 9 months before the onset of a recession, which means, if you are doing math, well *after* the yield curve has inverted. Put another way, in the last 50 years the stock has continued to rise for many months after the yield curve has inverted.

Not this time.

After its late September peak, the stock market had a very modest 5% pullback — until the day a portion of the yield curve first inverted. The below graph show the S&P 500 (blue, normed to 100, right scale) vs. the 5 year minus 2 year yield (red, left scale):

Literally, within a day that the first portion of the yield curve inverted, the S&P 500 fell into a bear market, and has remained there until a few days ago, when the yield curve came close to reverted to a normal positive shape across the duration spectrum.

Normally I stay away from ascribing reasons for any particular day’s stock market move. But in this case the evidence seem clear that in the aggregate traders decided that they needed no further information beyond the inverting of any portion of the yield curve before deciding that a recession was shortly to be upon us, with its necessary implication of a big decline in corporate profits.

This is of course the conundrum of forecasting: as soon as a leading indicator becomes well-enough known, economic actors react to it immediately, thus confounding its signal.

Which is one of the best reasons not to treat any single indicator as infallible.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.