The financial media are working themselves into a lather these days about a phenomenon known as “inversion of the yield curve” and its storied ability to forecast “recessions”. So much so that you’d be forgiven for thinking it was actually important.
You may suspect we’re joking. It’s not that the yield curve is uninformative or that the state of the economy is unimportant. It’s that both of these terms are used to reduce a rich spectrum of colors and shades of gray into a simplistic, binary, black or white.
What exactly is a “recession”? The conventionally accepted meaning is whenever the National Bureau of Economic Research says there is one. How’s that for scientific and objective? Some take it to mean two consecutive quarters of negative economic growth, as if there is some fundamental significance to dates like January 1, April 1, July 1, and October 1. Not to mention that it leaves open the question of just what exactly economic “growth” is, or if it’s even measured accurately.
But just for the sake of argument, let’s overlook these questions and assume that we have a reliable, objective definition of economic growth, a reliable, objective way to measure it, and that “recession” is happening whenever it’s below zero. In which case the mere use of the term obliterates any information whatsoever as to how far below zero it is. Or how far above zero it is not. A barely noticeable a -0.1% rate of growth is classified the same as an all out crash, but deemed different in kind than +0.1%.
A barely distinguishable difference between -0.1% and +0.1% determines whether or not a recession is in effect. Yet the worlds-apart difference between -0.1% and -10% are assigned the same name. And so are +0.1% and +10%. The term draws a completely arbitrary line between very similar states while grouping together very different ones. No such thing would be tolerated in any area of real science.
We have a similar complaint with yield curve “inversion”. A seemingly innocuous statement like “the yield curve is inverted” gives the impression its utterer has said something intelligent or profound. Yet the statement by itself says nothing about which two arbitrarily selected points between thirty days and thirty years are under the microscope or by how much the yield of the former falls short of the latter.
As if it makes no difference. And it still suffers from the same defect as the concept of “recession” … reducing a whole spectrum of information to a simplistic binary variable.
Why does it matter? Because these words are tossed around as if something fundamental about the financial system is changed when the yield curve passes one magic threshold or the rate of growth sits just one side or the other of another. Investors are supposed to invest differently and policymakers are supposed to make policy differently. There is no more difference between -0.1 and +0.1 than there is between +1.9 and +2.1, but one is worthy of headlines and the other is not?
If so, is it not possible that it might lead investors and policymakers to faulty decisions?
Sloppy economics has consequences.
But you may still be wondering if there is anything to this notion, at least broadly, that an area of the yield curve in which rates decrease as the term increases has any concrete implications. Yes it does. It means the bond market expects a decrease in short term interest rates in that time frame. The yield curve represents a kind of running accumulation of the short term rates expected at each point along the curve.
Yet we still haven’t crossed any magic lines. But it does suggest that stock returns will likely be unusually low some months ahead. Say, maybe around the end of this year? But if you’re a Financology reader, you’re already aware of that. Synthetic Systems told us that back at the beginning of January, the October before, and before that. Now the yield curve is just coming around to its point of view.
5 thoughts on “Inversion, Recession, and Other April Fools”
HERE’S A MORE CONVENTIONAL ASSESSMENT
Yield Curve: Meaning of Inversion
The yield on two-year Treasurys exceeded that on the 10-year three separate times last week. The phenomenon, known as “yield curve inversion,” occurred for the first time on Tuesday lasting less than a minute, and recurred on Thursday. On both days, the yield curve ended being slightly positively sloped. It was not until Friday that the curve inverted convincingly — ending the day with the yield spread at negative 8 basis points. The spread had narrowed by a significant 12 bp during the last trading day of the week. By comparison, the yield spread had been 80 bp at the start of 2022.
Inversion of the the yield curve is closely followed as a precursor of recession. Why is it an important indicator, and why did we have to wait until Friday for the curve to be inverted through the close of trading?
The yield on 10-year Treasurys is normally well above that on the two-year because of the longer time period that the funds are lent for. On the other hand, when investors fear a recession, they are willing to lock the yield for a longer period of time in a safe-haven security, pushing the long-term yield lower than the short-dated paper.
A second reason is that the two-year Treasury yield is considered to be the best leading indicator of Federal Reserve policy. When this yield goes above that on 10-year Treasurys, the move would suggest that bond investors believe that the central bank is going to raise rates so high as to push the economy into recession.
For example, the 2 – 10 yield curve inverted several times during 2006 in a sustained fashion, i.e., lasting several days. While equity investors toasted what they believed was a robust economy by pushing the S&P 500 index to a record high in October 2007, the Great Recession began a couple of months later. The bond market had anticipated the recession more than a year earlier. The equity market just did not.
A third reason for the significance of the shape of the yield curve comes from the financial sector. Banks depend on a positively sloped yield curve for their earnings — to be able to borrow short-term at a low interest rate and to lend long-term receiving a higher interest rate. When this is reversed, the lenders would be better off not lending — and that would hurt economic growth.
The persistence of curve inversion on Friday is traceable to the strong job numbers released by the Bureau of Labor Statistics that morning. The US economy created 431,000 jobs in March but with the annual growth in average hourly earnings accelerating from 5.2% in February to 5.6%. This ended any doubt in bond investors’ minds that the central bank would raise rates several times, even by 50 bp on occasion, in its efforts to lower both wage and price inflation.
However, neither the persistent supply bottlenecks — not from covid this time, but as a fallout from the Russia – Ukraine conflict — nor the surging price of energy will respond to Federal Reserve policy. The developments are changes in the global economic structure. What higher interest rates would do instead, the Treasury bond market reasoned, is push the economy into recession.
What about Fed Chairman Jerome Powell’s assertion on March 16 that “the probability of a recession within the next year is not particularly elevated”? Responding to a journalist’s question, Powell justified his stance noting that “aggregate demand is currently strong” and “the labor market [is] also very strong.”
Economists who have witnessed several business cycles know that it is hazardous to extrapolate simply based on the current state of the economy. It is easy for an individual at the edge a precipice to have an illusion of being on top of the world!
Dr. Komal Sri-Kumar
Thanks for posting this JK. Of course the goal of this post is not to celebrate, but to indict, the “conventional assessment” and to provide a superior alternative. I usually don’t single out examples of faulty analysis by name because, well, it’s mean … and because the errors are not the fault of the individual anyway. But you’ve just done it for me. Sri-Kumar for example is one of the best in the field and despite these problems always has something interesting or valuable to say.
But the field is a mess. If conventional economics were so good, why the 1970s? Why 2008? How did debt get so out of control? Why has the wealth gap exploded? Why do we have near double digit inflation? Our leadership certainly has access to the finest conventional economics has to offer. It just doesn’t have much to offer. This site exists to fix that.
Again, this is not to pick on this particular analyst. He has built as solid a structure as could be expected on the foundation of sand he had to work with. But sand it is. For starters, the selection of two particular points on the yield curve and associating them with the power to predict the fuzzy construct known as “recession”.
What’s the justification for the selection of those points and the associated conclusion? Statistics. In other words, it’s not some well-defined chain of causation that specifically links the two and ten year yield spread with the subsequent occurrence of “recession”, but mere statistical association.
We aren’t fans of statistical economics. The similarities between any two sets of circumstances are muddied with myriad differences. In this case, the problem is fatally compounded by too small a sample set. No valid conclusion can be reached.
Contrast that with the Financology formulation. It says a negative slope occurs in a portion of the yield curve associated with market expectations for a decline in short term rates. We don’t try to pin fuzzy connotation-loaded names on it. Instead we stick with the objective, accurately quantifiable, conclusion that the market expects a decline in rates. Free of subjective, dumbed down baggage, we leave readers to conclude for themselves what state of the economy and markets might be associated with a decline in short rates. It might be a decline in “growth” (whatever that is), or it might be a decline in … inflation.
But we don’t stop there; instead of speculating about an invalid statistical association implying an ill-defined outcome, we go straight to what investors are interested in, and what is objectively quantifiable, the market outlook. There we see what the conventional crowd might also see, but as pointed out above, we saw it first.
“However, neither the persistent supply bottlenecks — not from covid this time, but as a fallout from the Russia – Ukraine conflict — nor the surging price of energy will respond to Federal Reserve policy. The developments are changes in the global economic structure. What higher interest rates would do instead, the Treasury bond market reasoned, is push the economy into recession.”
This part of Dr Sri-Kumar’s article merits its own response. He implies that “persistent supply bottlenecks” and associated price increases are the result only of real factors such as covid and the war in Ukraine.
Gotta call bullshit on this one. No chance inflation had anything to to with the Fed slamming rates down to zero, holding them there way too long, and printing by the trillions? No chance supply bottlenecks had anything to with the government response to covid and the the government response to the war?
That “supply bottlenecks” themselves can be a symptom of inflation appears not to have even been considered. Yet that’s just what you would expect. Due to friction sand inertia, what if prices actually fail to keep up with an inflationary onslaught? Sellers have been known to try and hold the line on rapid price increases. Wages are notoriously slow to adjust. This results in prices – despite their increases – still falling below the market clearing level. In which case, from Econ 101, we know that supply fails to meet demand.
This is not to say supply chain chinks aren’t real or that covid and the war played no role. But the suggestion that they have nothing to do with monetary policy is false.
By extension, he implies that the only thing the Fed would accomplish with higher interest rate policy would be to cause a “recession”. He doesn’t define exactly what that means but implies it would be something bad. At least, worse than the consequences of failing to raise rates … but he doesn’t explore that side of the question, so his conclusion is suspect at best.