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Why the US yield curve recession signal could prove misleading

Posted on Tuesday, August 20, 2019 at 12:19PM by Registered CommenterSimon Ward | CommentsPost a Comment

Investors were spooked last week by a further inversion of the US Treasury yield curve but the manner of the inversion casts doubt on the validity of the associated recession warning.

Monetary trends are judged here to be a better guide to economic prospects than yield curve movements but the US curve has an impressive record of predicting recessions since the mid 1950s.

The headline development last week was a fall in the 10-year Treasury yield below the 2-year yield, although the cross-over subsequently reversed.

The 10-year / 2-year spread is the favoured curve measure of many market analysts but the 10-year / 1-year spread has a slightly superior historical forecasting record. The latter turned negative ahead of all 9 recessions since the mid 1950s, with only one false signal, in 1965-67 – see first chart. The 10-year / 2-year spread gave an additional false signal in 1998.

Source: Federal Reserve, NBER

The 10-year / 1-year spread turned negative in early August (it had done so briefly in March and May) and the inversion has persisted.

The recent inversion, however, is unusual because it has been driven solely by a decline in longer-term yields.

The second chart separates the 10-year / 1-year spread data according to whether the 1-year yield was higher (red) or lower (green) than 3 months before. All previous inversions, including the false signal in 1965-67, involved a rise in the 1-year yield in addition to or instead of a fall in the 10-year yield.

Source: Federal Reserve, NBER

This distinction suggests a higher risk that the current signal will prove to be false, unless the 1-year yield rises and the curve remains inverted.

Narrow money trends, while continuing to signal weak economic prospects, are not obviously recessionary. The third chart shows the behaviour of real (i.e. CPI-deflated) narrow money before and after the start of the last 9 recessions (red lines) and the 1966-67 slowdown associated with the false yield curve signal (green line). Real narrow money contracted in the 12 months preceding the recession / slowdown start dates but has risen over the past 12 months (blue line).

Source: Federal Reserve, BLS, NBER

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