WHAT'S THE YIELD CURVE TELLING US?
There is much discussion about the inverted yield curve and what it means. Many are saying that an inverted yield curve, where short-term rates are higher than long-term rates, “always” precedes a recession. This bit of market lore, though, depends on a lot of basic definitions that are not often questioned. But I’ll give two: (1) which maturities on the yield curve are we talking about, and (2) what definition of recession are we using?
As for maturities, many use the 2-year/10-year yield spread, which has been narrowing. But the 30-day/10-year spread, another popular choice, has been widening. Meanwhile, Fed Chair, Jerome Powell, has stated that Fed research1 shows the 2/10-year spread results are probably spurious, and we should look at maturities of less than 2 years.
Meanwhile, what’s a recession? A popular definition is 2 quarters of negative GDP growth. But the NBER in the US has stated that they actually use multiple factors, and a committee decides if there is a recession. At the OECD, a recession is defined as growth slower than a long-term trend. So even the definition of what we’re trying to predict is ambiguous.
A while back, I decided to sidestep the ambiguity and revisit the three classic definitions of interest rate risk: slope (the 2/10-year spread), convexity (the 10-year yield minus the average of the 2/30-year spread) and the term premium. I found that it’s the trend in these factors that gives us our first clue as to what’s going on. Right now the trend suggests that the US economy is still growing and current Fed policy is not enough to cause a recession. Of course, things other than interest rates can cause a recession. That’s why the yield curve by itself is not enough to make such a forecast.
1“(Don’t Fear) the Yield Curve Reprise,” March 25, 2022. https://www.federalreserve.gov/econres/notes/feds-notes/dont-fear-the-yield-curve-reprise-20220325.htm
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