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Yield Curve As Predictor Of Recession

Yield Curve as Predictor of Recession

The past months have whipsawed investors.  2018 closed with most asset classes down after a turbulent December.  2019 opened with sharp gains in most asset classes, reversing prior declines.  These jarring moves have investors searching for an explanation, and one of their impulses has been to look for alarm bells.  A common alarm bell is a measure of bonds’ yields known as the yield curve.

The yield curve measures the difference in yields between a short-term government bond, like a 2-year U.S. Treasury Note, and long-term bond like a 10-year U.S. Treasury Note.  The 10-year bond makes a big ask of investors.  It asks them to lock their money into today’s yields for a decade, so in normal times, investors expect a premium potential return – a higher rate of interest.  The yield curve is said to be inverted when this relationship breaks down, and longer-term bonds don’t offer their historical premium yield and instead yield less.  The reason this is significant is that investors would only lock their money up for long periods of time without a better yield if they were pessimistic about the economic outlook.

Yield Curve as an Indicator

History of the U.S. suggests that an inverted yield curve can be a predictor of a recession, though it’s an imperfect one.  The actual recession can happen 6 months later or 3 years later, and can be shallow or deep, and may or may not be accompanied by a bear market in stocks.  History outside the U.S. is less encouraging still.  Many developed economies faced inverted yield curves before without facing a recession for many years later, suggesting that bond trades don’t always do a good job of predicting the economy.

Yield Curve as a Message to Investors

I believe that there are reasons today to doubt the yield curve’s message to investors.  The first is that the yield curve has yet to actually invert.  As of April, longer-term bonds still offer a small premium yield relative to shorter-term bonds.  The second, that the yield curve’s ability to predict timing of recessions, is extremely limited and can fall in a range that encompasses years.  The third and most important reason to doubt the message has everything to do with today’s environment.  The Federal Reserve has made big moves in the bond market since the Great Recession in 2008 and has had a direct impact on the shape of the curve over time.  When it tried to stoke economic growth, the Fed brought short-term yields to all time low levels and made the curve artificially steep.  Later, it purchased longer-term bonds in a move called “Operation Twist” in a move that lowered the premium yields of longer-term bonds.  Finally, in recent years it has increased short-term interest rates and this has had the direct effect of flattening the yield curve.

The bottom line: the yield curve has an interesting history and can tell us much about investor expectations of the economy and its pattern of growth.  Its track record for predicting recessions limits its use to investors, though, and there are special reasons today to take its message with a grain of salt.  The best way to make sense of an uncertain prediction is to look past it and focus instead on the long term.  Investors may find that now is a good time to re-evaluate their portfolios and their risk tolerance.  The volatile markets of the past six months serve as a good chance to reassess an investor’s relationship with the riskiness of their portfolio and the level of risk they’re comfortable taking.

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