Certainly no one would claim that an inverted yield curve would predict a recession caused by a supply-side shock and I predict the Federal Reserve will be relatively good at preventing recessions going forward so hopefully this debate isn’t relevant for the foreseeable future, but I still contend that it’s best to do away with the idea that an inverted yield curve is some great predictor of recession.
The yield curve illustrates how the yields of bonds differ as a function of their maturity. Lately, there has been much discussion about government borrowing particularly regarding how much the U.S. can borrow until it is met with real constraints and costs. When the U.S. borrows money to finance its spending programs, it does so by selling bonds at auction. The Treasury puts these bonds on the market and attached to them are a wide range of maturities ranging from a few weeks to up to 30 years. Thus, the yield curve shows you the interest rates on bonds at varying maturities.
If you were a participant in the bond market and were looking to purchase a bond, you would play an integral role in setting the rate for a bond. In the short-term, there is more information for you to work with, less uncertainty, and thus you’re able to get a better assessment of inflation expectations. Because of this, you don’t demand a higher rate on a bond with a short maturity - a bond that is in line with the level of risk for purchase. As maturity increases, so does uncertainty and inflation risk, so you’re more likely to demand higher rates for long-term bonds. Thus, the interest rate the Treasury auctions is lower for short-term bonds and higher for long-term bonds.
Now, there are periods of time where something ominous happens, where the interest rate on short-term bonds is higher than that on long-term bonds. This results in the flattening and eventually inversion of the yield curve. This would imply market participants having uncertain or negative outlooks that could indicate economic downturn.
It is crucial to step back and define two concepts: The Liquidity Effect and The Fisher Effect. The Liquidity Effect illustrates how an increase in the availability of money, to match the demand for money, leads to a decrease in nominal interest rates. The Fischer Effect illustrates how an increase in inflation leads to a decrease in nominal interest rates. Confusing? Stop reasoning from a price change. Indeed, low rates can be a sign that money has been too tight, leading to a depressed economy - you need to know what caused the change in price. The Liquidity Effect leads to higher inflation; The Fisher Effect leads to lower inflation.
The Fisher Effect is generally a long-term effect even though it might be “happening” in the present - in the long run, we might be dead, but looking backwards, we also live in the long run. Hence, long-term bonds are generally more sensitive to the Fisher effect relative to short-term bonds. If there is a decrease in long-term bonds, one should expect markets to forecast a modest amount of deflation. Short-term bonds, on average, are consistent with the Federal Reserve’s intermediate target, the Federal Funds Rate(FFR). If monetary policy is on course - if the Fed is credibly committed to achieving its dual mandate - then a modest forecast of deflation would lead to a decrease in long term yields and no change in short term yields. An inversion will only occur if markets forecast an ample amount of deflation, and likely, that deflation being somewhat unexpected. This is the general intuition of why inverted yield curves occur before recessions. This is true, but it is not synonymous with it being a predictor of a recession.
The simple critique is the inverted yield curve having a 22 percent false positive rate over a low sample size. While I wouldn’t ignore an inverted yield curve, this would be enough for me to be dismissive of it being some grand indicator for recessions, but some would disagree.
Well, yield curves certainly invert, so do they predict anything? Yes. The yield curve predicts the path of interest rates - a yield curve inversion would predict a rate cut. If your internal thought to that statement was “but the Fed cuts rates during recessions” then you’re reasoning from a price change. The Federal Reserve cuts rates to prevent recessions - that’s the important distinction. The yield curve will also not indicate whether we’re operating under The Liquidity Effect or The Fisher Effect.
Consider this quote:
Longer-term yields can be conceptually divided into (1) the average expected short rate over the life of the security, and (2) the difference between the total yield and the average expected short rate, known as the term premium. To a first approximation, portfolio balance effects work by affecting the term premium, while the signaling effect works by influencing expectations of future short rates. Using that approximation to distinguish the portfolio balance and signaling channels is not straightforward, however, because term premiums and expected future short rates are not directly observable. There are also indirect effects to account for: For example, changes in term premiums arising from the portfolio balance channel, if they influence the economic outlook, will also affect expectations of future short rates. If QE successfully reduces longer-term interest rates, through either portfolio balance or signaling channels, then the presumption is that the economy will respond much in the same way 7 that it does to conventional monetary easing, as a lower cost of capital, higher wealth, a weaker currency, and stronger balance sheets increase spending on domestic goods and services.
- “The Lucas Critique” -
The Federal Reserve instituted Quantitative Easing (QE) with a goal of reducing the risk premium through a flattening of the yield curve. Through a reduction in long-term rates the economy would experience the same environment under conventional monetary easing policies. You can’t reason from a price change, an inversion could indicate an increase in output. If the yield spread had causal impact, which is the line of thinking one must adopt under a “inverted yield curve → recession” view, then a QE policy that would flatten the yield curve would be contractionary. Of course, this did not happen.
Consider Gürkaynak, Sack, and Swanson (2004):
First, federal funds futures clearly dominate other market-based measures of monetary policy expectations at horizons out to about five months. Their predictive power for the future federal funds rate is higher, their risk premium is lower, and we cannot reject the hypothesis that they encompass the information contained in all of our other market-based forecast measures combined. Second, for horizons longer than a few months, eurodollar futures seem to provide the best measure of monetary policy expectations, but a number of other instruments are of comparable quality. This latter finding may reflect the degree to which these markets are integrated with one another
If you think an inverted yield curve is a forecaster, why not use the Federal Funds Future Contracts? Why not use Eurodollar futures contracts? Why not use the TIPS spread? Perhaps you don’t find any of this persuasive; perhaps you’re fine with being “wrong” sometimes even if you accept your terminology might be off. The Yield Curve certainly has value, an insane amount of value, and unlike other market indicators it goes 30 years into the future. However, it’s still pretty damning to claim it’s an indicator of a recession; in my opinion, it’s also an indictment against the field if we claim such.
In late 2007, money was certainly too tight. I wonder what the yield curve was.
"Fischer Effect illustrates how an increase in inflation leads to a decrease in nominal interest rates." I thought they moved in tandem?