Is The Yield Curve Still A Reliable Recession Indicator?

WASHINGTON, DC–Recession-watchers have been eyeing the morphing of the yield curve with growing alarm and little wonder. The current spread between the federal funds rate and the 10-year Treasury note yield is 95 basis points, when using the upper end of the fed funds range of 2%, per our sister publication ThinkAdvisor. A year ago, before three subsequent rate hikes, the spread was 101 basis points. Typically during periods of continued economic growth the spread is 250 basis points or more.

An inverted yield curve, as most economists will tell you, is seen as a reliable indicator of a recession.

Indeed James Bullard, president of the St. Louis Fed, warned in a presentation delivered in Scotland recently that “there is a material risk of yield curve inversion over the forecast horizon if the FOMC continues on its present course.”

A Change In Thinking

While there is no doubt that the yield curve is moving towards an inversion, what about the second piece of that equation? What if an inverted yield curve was no longer the reliable indicator of recession that many believe it to be?

Some economists, including former Fed Chair Ben Bernanke and current Fed Chair Jerome Powell, a former banker, aren’t convinced that an inverted yield curve in the current macro market suggests a recession is coming, ThinkAdvisor writes.

At a recent event focused on the financial crisis, Bernanke said, “Historically the inversion of the yield curve has been a good [sign] of economic downturns [but] this time it may not,” because of market distortions due to “regulatory changes and quantitative easing in other jurisdictions … Everything we see in terms of the near-term outlook for the economy is quite strong.”

Various analysts are also suggesting that the current yield curve isn’t necessarily signaling a recession. Standard Chartered Plc global head of G-10 foreign exchange research, Steven Englander, writes in a research note that once risk premiums are stripped out, “The adjustment makes the flattening of the yield-curve slope much less dramatic, and shows that it has quite a bit more room to go before it hits the lows of previous cycles.” (per Bloomberg).

And Cresset Wealth Advisors flat out says that the yield curve is distorted and will likely not continue to be the reliable economic forecasting tool it once was, thanks to overbearing central bank influence. (per Forbes.com). “Our bottom line is that a yield curve inversion, were it to occur, would prompt ominous headlines but would not be a recession signal,” it wrote in a research note.

The Classic Case

Bullard, however, made a strong case for fearing the inversion in his speech.

He said the empirical proposition that an inverted yield curve helps predict recessions makes sense as lower longer-term nominal interest rates may be a harbinger of both lower growth prospects and lower inflation in the future.

One could consider alternative term spreads and other information, he said, but “various term spreads tend to be highly correlated, so switching to somewhat different measures tends not to change the broad macroeconomic interpretation.”

Bullard explained that the 10-year Treasury yield is a bellwether rate determined mostly by market forces and that the one-year Treasury yield is closely related to Fed policy. “An inversion suggests a very different outlook at the Fed versus in the market,” he said.

Although Fed Chair Powell appears set to continue a gradual rising of interest rates, it is clear that there are voices within the Fed that are not as bullish — namely Bullard’s.

“The simplest way to avoid yield curve inversion in the near term is for policymakers to be cautious in raising the policy rate,” he said.