Yield Curve Isn’t a Great Recession Indicator Anymore

Since June 2022, the yield curve — the difference between has been inverted. Not intermittently, but continuously. Non-stop. To economists, that was like a smoke detector so high off the floor that no one could pull out the battery. (Not that they should.)

It’s supposed to be a classic indicator of a recession that should arrive between 12 and 24 months. It’s only been wrong once since 1955. Well, until now. The economy could turn upside down in the next few months, but that currently doesn’t seem likely.

A recent Reuters poll of bond market experts showed 22 of the 34, 64.7% — a small sample — have lost at least some faith in the predictive power.

“If you have these two things going on together – insatiable demand for the long-end from real money like pension funds and the Fed keeping front-end rates higher because of the resilience of the economy – the curve will stay inverted for a while,” Zhiwei Ren, portfolio manager at Penn Mutual Asset Management, told Reuters.

For years, the Federal Reserve heavily bought Treasury securities since the Great Recession in 2007-2008 as part of its attempt to stimulate the economy by increasing liquidity, a strategy called quantitative easing.

“Many observers have argued over recent years this ownership is distorting market pricing, although strategists interviewed to discuss the latest poll results did not mention suppressed yields via ‘quantitative easing’ as a reason,” Reuters wrote.

The reason for the latter is that Fed purchase and holding of Treasury instruments would be demand that should push up bond prices, which are supposed move inversely to yields, which should have dropped.

However, since May 2022, the Fed has done the opposite — quantitative tightening — to fight inflation as part of its monetary policy.

At the same time, expectations of rapid Fed reversals of interest rates pushed the 10-year to lower values. That has reversed as markets have come to think the cuts wouldn’t happen.

There is another potential factor in play, as the St. Louis Fed noted in 2021: “Peaks in employment growth follow peaks in the spread between yields on the 10-year and two-year Treasury notes. In addition, the spread is widest generally following recessions, when expectations of future growth are highest after a trough in the economy. This pattern appears generalizable and consistent over the past 25 years.”

The overall economic conditions have been acting in ways that have come to make big names in economics to scratch their heads. While many were pointing to the Phillips Curve, claiming that reduction of inflation would of necessity require an increase in unemployment, the opposite has happened. Conditions have managed to allow a fall in inflation while employment continued to grow.

Maybe it is a product of the enormous fiscal stimulus the government engineered during the pandemic. Perhaps it’s something else. But it does seem as though things that once seemed expected are no longer. Employment growth has matched negative yield spreads, and the economy keeps humming along. Perhaps it’s time, at least for now, to reduce the kneejerk attention to the yield curve.