As a predictor of U.S. recessions, an inverted treasury yield curve has been like a crystal ball foretelling recessions for over 70 years. The terms inverted, or negative yield curve are used when shorter maturity interest rates are greater than longer maturity rates. So if one plotted the interest rates of all different maturities on a graph, the plotline would reveal a downward slope.
The rule-of-thumb applied to this economic forecasting hack is that an inverted yield curve signals to economists and market watchers that in one year, there is a high probability of an economic downturn. This unofficial indicator has been so exceptionally accurate that the website for The Federal Reserve Bank of Cleveland asserts a downward-sloping yield curve has “preceded each of the last eight recessions.”
What is the Yield Curve?
Let’s start off by explaining what the yield curve actually is. The yield curve is a tool that plots interest rates for different bond maturities. It plays a vital role in economic analysis. Normally, short-term bonds have lower yields compared to long-term bonds. However, when the yield curve inverts, like it has for almost two years, it indicates a situation where short-term bonds offer higher yields than long-term ones.
This phenomenon can be driven by market expectations and perceptions of future economic conditions. Investors may favor short-term bonds over long-term ones due to concerns about potential economic downturns or a lack of confidence in long-term stability. As demand for short-term bonds increases, their prices rise, causing yields to decrease, which can result in the inversion of the yield curve. Additionally, actions by central banks, such as cutting short-term interest rates to stimulate the economy, can contribute to this inversion by further reducing short-term bond yields.
Why Inverted Yield Curves are Predictive
The “magic” of the inverted yield curve as a reliable predictor of recessions is powered by the combined wisdom of market participants.
The multitude of investors worldwide, through their buying and selling with the future in mind, reveal the wisdom of the masses. This is evident through the yields they are willing to accept and whether they anticipate interest rates to decrease in the future.
For example, if decelerating growth is within investors’ expectations, they would collectively anticipate the Fed to reduce interest rates. This is because lowering interest rates is the primary tool the Fed uses to stimulate the economy in response to an economic downturn.
Therefore, the inverted yield curve serves as an early warning signal for potential economic recessions, as it reflects investors’ pessimism about future growth prospects and their anticipation of central bank interventions to mitigate economic risks.
Persisting Inverted Yield Curve But No Recession
The yield curve has remained inverted for almost two years. Despite the economy growing, the inverted yield curve hasn’t foretold a recession as expected. Currently, the yield curve shows a difference of over one percent between short-term overnight rates at 5.25%, two-year rates at 4.59%, and ten-year rates at 4.22%. This means there’s a negative 1.03% curve, signaling an unusual investment trend that defies typical expectations (5.25% – 4.22% = -1.03%).
Interestingly, the term ‘recession’ finds its roots in ‘recede,’ signifying a backward movement, but in this instance, the economy has shown a consistent forward trajectory. The GDP for the fourth quarter, a key indicator of economic expansion, is projected to have increased by 3.2%, showcasing ongoing growth. Preceding this, the U.S. economy exhibited rapid expansion with a staggering 4.9% growth rate in the previous quarter.
Despite these positive trends, the yield curve incorrectly predicted, nearly a year in advance and even further back, that a recession was imminent, creating significant uncertainty among investors.
Has the Yield Curve Lost its Economic Forecasting Ability?
Experts aren’t as certain that the yield curve’s slope can forecast an economy destined to shrink as flawlessly as it used to. In fact, a Reuters poll of bond market experts discovered that nearly two-thirds of strategists, when asked, said the yield curve’s predictive power is not what it once was.
One key factor contributing to the decline in the yield curve’s predictive ability is the significant intervention by the Federal Reserve during events such as the 2007-2008 financial crisis and the Covid-19 pandemic. The Fed purchased substantial amounts of bonds to strengthen the economy, resulting in a notable increase in the Fed’s ownership of outstanding bonds.
Consequently, the increase in the Fed’s holdings has indeed influenced the bond market, potentially impacting the traditional predictive power of the yield curve. The heightened bond purchases have pushed bond prices up, resulting in decreased yields.
Moreover, despite the ongoing economic growth, the Fed’s actions have played a role in shaping the currently inverted yield curve, potentially affecting market perceptions and conventional indicators. This deviation may challenge the reliability of the “wisdom of the masses” in interpreting market dynamics.
Key Takeaway
To sum it up, the inverted treasury yield curve, historically a strong predictor of recessions, has now faced challenges in its predictive power due to significant interventions by the Federal Reserve during economic crises. This increased involvement has influenced bond market dynamics, potentially diminishing the traditional predictive strength of the yield curve. Despite ongoing economic growth, the skewed influence of the Fed’s actions has contributed to the faltering reliability of the inverted yield curve as an economic forecasting tool.
