Today Another Key Curve Metric Inverted, Raising Recession Risk

ASSOCIATED PRESS

In March the yield on the 10-year fell below the yield on the 3-month Treasury bill. Today, the yield on the 10-year fell below the yield on the 2-year spooking the markets. The yield curve is normally upward sloping as debt further into the future pays more interest. Sometimes that relationship breaks down. Today it broke down further. The yield curve is becoming more inverted. Let's explore why that might matter.

A Recession Predictor

Historically an inverted yield curve has been a robust recession forecaster. Inverted yield curves typically come several months before a recession. Not only is this correlation relatively robust over history, but there's reason to think the relationship may be causal. First off, a downward sloping yield curve implies the Federal Reserve (Fed) is looking to cut rates. Generally the Fed cuts rates when they are concerned about the health of the economy. So the market assuming the Fed will cut, is essentially saying the Fed sees recession risk as high.

Furthermore, an inverted yield curve complicates lending. Why should banks lend money long term, when they can receive better rates on short-term lending? That behavior may make sense, but it can starve longer term projects that support growth of funding. This is also a worry, coming at a time when equity markets especially in the U.S. seem expensive, it's unclear how much downside risk is priced in at these levels.

Estrella and Mishkin performed much of the research behind yield curve inversion while at the New York Fed. They actually chose to work off the relationship between the 10-year and 3-month rates which inverted back in March. However, other like to look for broader inversion across the yield curve and with today's move we're seeing that play out. Today their model suggests a 30%-40% chance of a recession on a 12-month view.

Below you can see how these key relationships have held up through 2019. The 10-year just dipped below the 2-year today, but the 10-year and 3-month are becoming more deeply inverted.

Year Curve Inversion In 2019

Federal Reserve data, author's analysis

Reasons Not To Panic

Yield curve inversion is a bad sign, but there are still a few reasons for mild optimism. First off, this is a leading indicator. It's unlikely we're in a recession yet, for that the best indicator is believed to be rising unemployment. We're not seeing that yet, so the yield curve is generally early and could possibly be wrong. Some argue that the global trend towards negative rates and low yields in absolute complicates the signal from yield curve inversion. For example, former Fed Chair, Yellen thinks the signal may be false this time.

Let's unpack what the academic model is really saying. Today it suggests, on academic models, perhaps a 3 or 4 in 10 chance of recession within a year. To put that in context, in an average year historically there's about a 2 in 10 chance of recession the next year. So the metric is still saying that it is more likely that we do not get a recession than that we actually have one. So we may get lucky and miss a real dip, but with Chinese trade not improving and the UK apparently on course for a no deal Brexit, global risks may be rising. Of course, if the yield curve becomes more inverted over time, as we've seen in recent weeks, then this story may get worse.

Furthemore, our most recent experience of recession in the U.S. was 2008-9. That one was particularly nasty. Almost a once in a lifetime event. It's unlikely that the next recession is as severe at this one. This point is worth mentioning, because 2008 is what most think of when they hear recession given their recent experience.

So the outlook for the U.S. economy just became a little more gloomy, but there's still a way to go before we can be sure a recession is really coming. Now is a good time, as ever, to make sure that your portfolio is well-diversified for what the future holds.

 

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ASSOCIATED PRESS

In March the yield on the 10-year fell below the yield on the 3-month Treasury bill. Today, the yield on the 10-year fell below the yield on the 2-year spooking the markets. The yield curve is normally upward sloping as debt further into the future pays more interest. Sometimes that relationship breaks down. Today it broke down further. The yield curve is becoming more inverted. Let's explore why that might matter.

A Recession Predictor

Historically an inverted yield curve has been a robust recession forecaster. Inverted yield curves typically come several months before a recession. Not only is this correlation relatively robust over history, but there's reason to think the relationship may be causal. First off, a downward sloping yield curve implies the Federal Reserve (Fed) is looking to cut rates. Generally the Fed cuts rates when they are concerned about the health of the economy. So the market assuming the Fed will cut, is essentially saying the Fed sees recession risk as high.

Furthermore, an inverted yield curve complicates lending. Why should banks lend money long term, when they can receive better rates on short-term lending? That behavior may make sense, but it can starve longer term projects that support growth of funding. This is also a worry, coming at a time when equity markets especially in the U.S. seem expensive, it's unclear how much downside risk is priced in at these levels.

Estrella and Mishkin performed much of the research behind yield curve inversion while at the New York Fed. They actually chose to work off the relationship between the 10-year and 3-month rates which inverted back in March. However, other like to look for broader inversion across the yield curve and with today's move we're seeing that play out. Today their model suggests a 30%-40% chance of a recession on a 12-month view.

Below you can see how these key relationships have held up through 2019. The 10-year just dipped below the 2-year today, but the 10-year and 3-month are becoming more deeply inverted.

Year Curve Inversion In 2019

Federal Reserve data, author's analysis

Reasons Not To Panic

Yield curve inversion is a bad sign, but there are still a few reasons for mild optimism. First off, this is a leading indicator. It's unlikely we're in a recession yet, for that the best indicator is believed to be rising unemployment. We're not seeing that yet, so the yield curve is generally early and could possibly be wrong. Some argue that the global trend towards negative rates and low yields in absolute complicates the signal from yield curve inversion. For example, former Fed Chair, Yellen thinks the signal may be false this time.

Let's unpack what the academic model is really saying. Today it suggests, on academic models, perhaps a 3 or 4 in 10 chance of recession within a year. To put that in context, in an average year historically there's about a 2 in 10 chance of recession the next year. So the metric is still saying that it is more likely that we do not get a recession than that we actually have one. So we may get lucky and miss a real dip, but with Chinese trade not improving and the UK apparently on course for a no deal Brexit, global risks may be rising. Of course, if the yield curve becomes more inverted over time, as we've seen in recent weeks, then this story may get worse.

Furthemore, our most recent experience of recession in the U.S. was 2008-9. That one was particularly nasty. Almost a once in a lifetime event. It's unlikely that the next recession is as severe at this one. This point is worth mentioning, because 2008 is what most think of when they hear recession given their recent experience.

So the outlook for the U.S. economy just became a little more gloomy, but there's still a way to go before we can be sure a recession is really coming. Now is a good time, as ever, to make sure that your portfolio is well-diversified for what the future holds.

 

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Simon is Chief Investment Officer at Moola, and author of Digital Wealth and Strategic Project Portfolio Management. Articles are informational only, not investment adv

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