The yield curve is almost flashing recession, maybe, but who knows when

Predicting recessions involves a lot of correlation and not a lot of causation. What many believe to be the best predictor comes from the Treasury market, and it’s back in focus: an inverted yield curve, or higher yields on short-dated bonds than long-dated bonds.

The correlation convinces many that we are on the verge of a flashing warning sign. The yield curve has inverted before every recession, and a common version is about to invert again. The spread between the two-year yield and the 10-year yield fell below 0.2 percentage point last week for the first time since the 2020 recession.

Jerome Powell, Chairman of the US Federal Reserve, in Washington on Monday.


Photo:

Valerie Plesch/Bloomberg News

There are issues with correlation, which I’ll get to in a moment, but think about causality first. Economic history has some pretty compelling explanations for many recessions, and it’s taxing for the gullible to think that the yield curve predicted at least two of them.

The 1973-1974 recession was clearly caused by the Arab oil embargo, which began in October 1973 after the US helped Israel to defend itself. The yield curve had inverted by March of that year (2-year Treasury data isn’t that far back, but 1-year yields rose above 10-year ones), ostensibly predicting a recession. However, Treasury traders had not predicted the war or the embargo, so how could they have predicted the recession?

The brief recession of 2020 was just as clearly caused by the pandemic, and we all remember why. The yield curve had inverted in 2019, but even the most extreme Covid-19 conspiracy theorist would have trouble believing that bond traders had given advance warning that Covid-19 was on the way.

The current focus of the yield curve is the US, but Europe, and particularly Russia-dependent Germany, is seen by economists as more at risk of an imminent recession. If the yield curve is a good indicator, Germany will be fine as the curve has steepened since the Ukraine invasion, not inverted.

Whisper it softly, but perhaps the yield curve isn’t quite as useful as many think as a recession alert.

Here we come back to the correlation question. It’s true that the curve inverted before every recession. But a warning that comes between one and three years before a recession — even ignoring the false alarms of 1965 and 1998 — is difficult for an investor to act on. It’s hard to hold onto bearish beliefs when stocks have been rising for years and you’re missing out.

For example, after the yield curve inverted in 1989, stocks rose more than a third before the recession hit in the mid-1990s. Likewise, those who switched from stocks to safer assets when the curve inverted in late 2005 saw the S&P 500 rise by more than a quarter and waited two years for the bet to pay off. It’s hard to tell the difference between being wrong and being right at this point, but early on.

Rather than warning of a recession, an inverted yield curve should be read as a sign to investors that the economy is late in its cycle. That means the Fed is tightening monetary policy to slow the economy. The deeper the curve inversion, the closer the cycle is to its end and, barring a soft landing, a recession.

The pioneer of the yield curve, Prof. Campbell Harvey of Duke University’s Fuqua School of Business, prefers to compare the three-month return to the ten-year return. The New York Fed likes this approach so much that they created a probability model based on the idea that the more inverted the curve, the more likely a recession is. At the moment the answer is not very likely at all; in February he put the probability of a recession in the next 12 months at 6%.

Frustratingly for those trying to stoke recession worries, the curve using the 3-month yield is actually further from inversion now than it was before the Russian invasion, as the 10-year yield has risen more than the shortest yields. The Fed could cause a recession by raising rates too quickly and too far — but it’s only raised rates once so far, so that remains an issue for 2023 or 2024, not today.

The answer of the naysayers – which I usually am! – is that the yield curve warning is often dismissed: this time it’s always different. Deutsche Bank strategist Jim Reid highlights comments by former Fed Chair Ben Bernanke in March 2006 explaining why it would be OK at this point, and Chair Jerome Powell echoed Monday’s firings . He pointed to Fed research, which concluded that what really matters is the gap between three-month yields now and the implied three-month yield 18 months from now. If traders bet on many rate cuts over the next 18 months, they expect a recession. At the moment they are not.

An inversion in the US Treasury yield curve has been a warning sign of a recession for decades, and it looks set to flare up again soon. The WSJ’s Dion Rabouin explains why an inverted yield curve can so reliably predict a recession and why market watchers are now talking about it. Figure: Ryan Trefes

There will be a lot more talk about the yield curve as the increasingly hawkish Fed means it’s likely to be flatter and inverted with more and more action over the next few years. The correlation doesn’t automatically mean a recession is imminent, and certainly not anytime soon. But investors should watch causality closely. The higher interest rates go, the more likely the Fed is exaggerating and slowing down the economy too much.

Write to James Mackintosh at james.mackintosh@wsj.com

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