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Pundits Say An Inverted Yield Curve Predicts Recession -- We Say Hogwash

February 1, 2019

Friday, February 01, 2019

 

Dear Friends,

 

Inverted Yield Curve Definition

An inverted yield curve happens when bond yields at the short end of the bond spectrum rise above those at the long end.

 

Usually, the bond market focuses on the difference between the yields on U.S. Treasury two-year notes and those for 10-year notes.

 

Long-term Yield Spread Definition

The 2-year v 10-year yield spread is the long-term spread.

 

 

Inverted Yield Curve Fearmongering

You have read lots of articles recently that if the long-term spread occurs a recession will occur.

 

“For economists and investors, it’s a loud warning about the economy’s outlook.  One portfolio manager called the inverted yield curve (the long-term spread) a ‘harbinger of doom.’  It has a scarily accurate track record of predicting economic recessions, which in past decades have arrived six months to two years after an inversion.”  Source: A national business magazine online October 27, 2018

 

Global well-known brokerage firm:  “xxx expects the inverted yield curve — harbinger of recession — in 2019.”  Source: Marketwatch online, July 12, 2018

 

 

Balderdash on the Fearmongering

Yields on bonds beyond 18 months in maturity are shown to have no added value for forecasting either recessions or the growth rate of GDP.  Source: Finance and Economics Discussion Series

Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted Mirror Washington, D.C. July 2018 https://www.federalreserve.gov/econres/feds/files/2018055pap.pdf

 

 

Near-term Forward Spread

The Federal Reserve Board has said that they focus on the near-term forward spread.

 

“The near-term forward spread we focus on is the difference between the current implied forward rate (on Treasury bills) six quarters from now and the current yield on a three-month Treasury bill.”

 

“Thus, the near-term forward spread does indeed appear to be a pretty good gauge of market expectations regarding monetary policy. In particular, when the near-term forward spread is negative, it signals that investors expect the Federal Reserve to ease monetary policy in the near term. When do investors expect monetary policy easing? Presumably, when they anticipate a substantial slowing or decline in economic activity. Consequently, it is not all that surprising that negative readings for the near-term spread tend to precede (and thus can be used statistically to forecast) recessions. This does not mean that inversions of the near-term spread cause recessions. Rather, the near-term spread merely reflects something that market analysts already track closely--investors' expectations for monetary policy over the next several quarters and, by extension, the economic conditions driving those expectations. While, measures of the long-term spread also impound this information, they are likely to be affected by other factors unimportant for forecasting recessions, which would likely degrade their forecasting power.”

Source:  (Don't Fear) The Yield Curve, June 28, 2018 https://www.federalreserve.gov/econres/notes/feds-notes/dont-fear-the-yield-curve-20180628.htm

 

 

Conclusion

There is a lot of financial advice on the Internet – a lot of it is pure bunk!

 

Be skeptical and dig deep. 

 

 

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