Yield curve is often right for wrong reasons


A KEY part of the US yield curve inverted on Tuesday, which is a reliable indicator that a recession is coming. Or maybe not. 

So as economists, strategists and investors race to figure out whether this rare event in the bond market means the economy is poised to contract, there are a few key things to consider. 

The first is that every recession since the 1950s has been preceded by an inverted yield curve, but not every inversion has preceded a recession. 

The second is that the yield curve can be right but for the wrong reasons. Just consider the last time yields on 10-year Treasury notes fell below those on two-year notes, in August 2019. 

Yes, the economy went into a deep recession in the first half of 2020, but that was due to the pandemic. Covid-19 was not on anyone’s radar screen in August 2019. At that time, the concern was that the record economic expansion was tiring and that consumers were running out of steam. 

Perhaps if the pandemic had never occurred, the recession would have been avoided and the yield curve’s inversion would have turned out to be a false positive. 

What’s notable now is that economists are less worried about the economic outlook than the last time the curve inverted. The latest monthly survey by Bloomberg News found that economists put the chance of a recession starting in the next 12 months at 20%, in August 2019, it was 35%. 

Going back to the 1970s, an average of 20 months elapsed between an inversion — there have been six — and the start of a recession, ranging from 10 months after September 1980 to 33 months after June 1998, according to research firm Statista. A lot can happen in 20 months, as the onset of the pandemic has demonstrated. Some research suggests that the correlation between inversions and recessions is a relatively new phenomenon. 

Then there’s the issue of how severe an inversion is, with mild ones not leading to recessions. No doubt, the economy is struggling at the moment. 

The Federal Reserve Bank of Atlanta’s widely followed GDP-Now Index, which aims to track the economy in real-time, is predicting first-quarter growth of less than 1%. 

And there is no shortage of market participants who think that the only way the Federal Reserve 

(Fed) can get inflation under control is by raising interest rates so much that it puts the economy into a recession. 

But that’s not the consensus. The median estimate of economists surveyed by Bloomberg News is for the economy to expand 3.5% this year and 2.3% in 2023. That’s certainly not great, but it is in line with growth in the years before the pandemic. 

And there’s reason to think that the yield curve’s predictive ability has been diminished ever since the financial crisis of 2008 and 2009 and as the Fed and other top central banks have become more intertwined with bond markets. 

The economists at Wells Fargo & Co wrote in a research note on Tuesday that, as a result, “the link between curve shape and growth has been weak at best since 2009”. 

As they point out, the curve flattened steadily from late 2013 to late 2019, yet GDP growth was stable. 

Perhaps too much credit is given to the yield curve’s ability to predict recessions. It may yet turn out right again, but perhaps for the wrong reasons — again. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.