What The Yield Curve Tells Investors Now
The yield curve has a remarkably good record at forecasting recessions. Better than most forecasters. Here’s what the current curve signals for markets.
A Flat Curve
Currently the yield curve is extremely flat, going out 7 years, maturities rates are clustered around 2.5%. That’s unusual, typically the yield curve has a well-defined upward slope to it as longer bonds pay increasingly higher rates. Today it’s flat.
However, it’s also important to remember that a flat curve is not an inverted one. Yes, 3-year and 5-year rates are slightly lower than earlier maturities but only by up to 0.08%, and that’s basically a rounding error. Should the yield curve properly invert, that would be big news, but we are not there yet. At full inversion we can see longer rates sometimes 1% or more below short-term rates. We’re a long way from that currently, but we may be on the path to it.
What To Look For
Arturo Estrella and Frederic Mishkin did some the pioneering work on the yield curve here. What they found was that it’s important to look at the difference between the 3-month Treasury bill and the 10-year Treasury note. Once the 3-month bill is offering 1% more than the 10-year a recession is looking more likely than not on a 1-year ahead view, and at 1.5% level of inversion between the 3-month and 10-year, unfortunately a recession becomes extremely likely on their model. Currently, the 3-month bill offers 0.18% less than the 10-year bond. On their numbers that produces a 1 in 5 chance of a recession within 12 months, not especially high, yet not plain sailing either.
In practice, the yield curve tends to invert more as a result of short-term rates rising. In fact, other researchers have put more stock in high short-term rates being a driver of recessions than the slope of the yield curve itself. Either way, if short-term rates were to rise into the 3% to 4% range, then a recession would almost certainly be on the cards. Again, that’s not where we are today.
What Would Cause Rates To Go Up?
While there’s no crystal ball, it seems likely that what would cause higher short-term rates is higher inflation (rising prices). Both because higher inflation would cause bond holders to want higher rates to offset rising prices and because higher inflation may force the Fed to raise rates because keeping inflation in check is one of their goals.
So where are we with inflation? Currently core inflation (excluding food and energy) is running around 2% a year. That’s fairly muted, but watch this space. If wage growth picks up as it appears to be and if commodity prices keep rising as they have so far this year, that may ultimately translate into more inflation. Nonetheless, we aren’t there yet and those linkages could still take some time to play out, if at all.
Is The Model Accurate?
Nonetheless, despite all the concern about the inverted yield curve, does the model hold water, or has it just been lucky in the past? Well, it’s probably some of both.
The model is logical in that rising short-term rates may signal inflation, which suggests an expansion may be coming to an end, or simply that the returns on saving cash are better, causing companies to pull back on potential growth projects. Either way, higher short-term rates may signal, or prompt, slowing activity in the economy. So this is a model that makes some sense, and is unlikely to be a purely random relationship with no basis in theory.
However, the model has also probably been lucky. It’s done well in under 10 historic recessions. Unfortunately, that’s not a particularly robust test since we just don’t have enough historic data to go on. Recessions don’t come along all that often. Also, the idea of the importance of an inverted yield curve now gets so much attention that people may now even change their behavior because of it. That may make the consequences of an inverted yield curve in the future harder to predict.
So though the yield curve is not painting an upbeat picture for the economy, it isn’t flashing a major recessionary warning sign either. The thing to watch will be short-term rates, broadly speaking, if they move up over 3% then a recession may be coming within a year. However, the yield curve model may have been slightly lucky with forecasting success in the past and it may not have the iron-clad forecasting power that we anticipate this time around. Bear in mind that the stock markets understand this relationship quite well too, so don’t be surprised if should inversion occur, the stock market has already taken notice and fallen in value on recession fears.