US economy

Distorting the predictive power of the yield curve


I have a bet with some colleagues that we will see the yield curve invert before the end of next year. This hardly seems a bold call given that the gap between two-year and 10-year Treasury yields narrowed to below 20 basis points last week to a post-financial crisis low. So I’m going to propose another question on an even thornier issue — if the yield curve inverts, will we actually care?

In theory, we should. The yield curve charts the difference in compensation that investors receive for holding debt of different maturities. It usually slopes upwards to the right, to reward investors for locking up their money for longer. But if investors think the economy is about to go into recession, they demand a higher premium for holding short-term bonds than longer-term debt and the curve is inverted.

Yield curves have been better than most economists at predicting US recessions, although there is some debate about which part of the curve to use. Investors typically focus on the gap between two- and 10-year yields, while academics favour the spread between three-month bills and 10-year notes.

A paper from Federal Reserve board researchers suggests that a spread of short-term interest rates may be best. All three metrics turned negative a year or two before each of the seven US recessions since the 1970s. You can argue that one curve is better than another, but all of them put us economists to shame. As the Fed lifts interest rates during an economic recovery, the short end of the yield curve goes up. But the central bank has little control over longer-term rates. Those are determined by expectations for short-term rates, inflation and the “term premium”, the bonus investors demand for the risk of holding an asset for a longer period. If the economy seems to be faltering, investors expect inflation to ease and so longer-term yields fall.

While the yield curve has a successful record predicting downturns, seven recessions is not a huge sample size. Some economists argue that policy shifts and structural changes mean the yield curve’s signal is now distorted. The US Treasury is currently borrowing more money to finance predicted big budget deficits and it has mainly done so with short-term debt. That increase in supply has pushed the price of bills and short notes down and their yields up (bond prices and yields move inversely).

At the same time, global quantitative easing has created a seemingly insatiable demand for five- to 10-year Treasuries, pushing down yields. This means that the yield curve may be flattening for financial rather than economic reasons. Meanwhile, expectations for the neutral rate (when real gross domestic product grows at trend while inflation remains stable), inflation and term premia have been consistently lower than before the financial crisis. That means longer rates have been lower, making it easier for the yield curve to invert as short rates continue to rise.

Finally, deflation fears have made long-term bonds a useful hedge for equity investors concerned about a stock price correction. That also boosts demand and represses long yields.

All of these factors make it easier for the yield curve to invert, but none seems to reflect particular concerns about the economy. An inversion this time need not necessarily indicate a recession is nigh. I am sympathetic to the arguments that this time is different, but reluctantly so. Do not forget that in 2006, then-Fed chair Ben Bernanke insisted the yield curve’s signal was being distorted by structural factors, two years before the 2008 crash.

It may not matter whether the yield curve’s predictive powers are distorted. If the markets, companies and individuals believe an inverted yield curve means there will be a recession, they will behave accordingly. An economic downturn will then become a self-fulfilling prophecy — and I will win my bet.

The writer is global chief economist at Manulife Asset Management



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