With recent market volatility stemming from the administration’s assault on free trade, many investors have looked to classical market indicators to justify their belief that a recession is around the corner. One such indicator is the yield curve. A commonly used barometer for predicting coming recessions, the yield curve has successfully predicted each recession since 1975.
A typical treasury yield curve is upward sloping, with longer term interest rates exceeding short term rates as investors seek greater returns for capital being tied up over longer durations and the possibility of future inflation eating away at real returns. However, when the yield curve flattens or even inverts, this generally signals that investors are risk averse—predicting future disinflation or even deflationary pressure—and that the possibility of a recession is high.
Today, the spread between 10-year and 2-year treasury securities is at its lowest level since august 2007—right before the Great Recession. Normally, such a narrow spread would lead many to conclude that investors are cautious—bidding down long term yields as they expect either financial market turmoil or lower than expected inflation expectations—and that we are headed for economic doom. However, it is this author’s opinion that solely using this metric to guide economic decision-making is ill-advised for three reasons.
First, there is little real economic evidence to support the notion that economic growth will recede before the year’s end. Real GDP growth is holding steady at 2%, 213,000 new jobs were added in June, 600,000 people entered the workforce, and jobless claims are at their lowest level in 45 years, with only 1.72 million individuals seeking unemployment benefits for longer than a week—the lowest level since the early 1970s.
Second, the Federal Reserve is acting in a way that is anything but cautious. In the most recent Fed meeting, there were concerns about how the administration’s trade policy will affect growth over the near term, however these concerns in no way changed their outlook on the economy—as the FOMC still predicts two additional rate increases will be needed in 2018. If anything, they are worried the economy will overheat and inflation pressure will exceed forecasts, thus requiring the policy rate’s neutral setting to be adjusted further.
Third, the reason the yield curve has flattened is largely artificial, not market driven. In normal times, when the Fed raises the policy rate, there is typically a corresponding increase in long-term rates, as investors demand greater returns due to increased inflation expectations. However, today this isn’t the case. The fed has artificially pushed up short term interest rates as they believe inflation will persist, but investors have yet to bid down long-term treasuries, (perhaps due to the fact that many had unrealistic expectations about the economic impact of recent tax cuts). And yet this development is of little to no concern to monetary policymakers. If it were, those at the Fed would amend current tightening measures to be reflected in the yield curve—and do so with relative ease. Instead of letting long-dated treasuries mature, (as they are currently doing), they would simply sell them in open market operations. This would bid up long-term treasury yields and increase the slope of the yield curve. Voila. But being as they have yet to do this quite rudimentary trick, it is likely that they feel using the yield curve is of little analytical relevance to their decision making.
My point is that, often to our detriment, we imprudently glorify the wisdom of market technocrats, exalting them as economic prophets using technical methods only to underpin what are likely mere guesses on how the future will unfold. Now, more than ever, we need to broaden our analytical scope and look at the whole economic picture rather than one relatively simplistic indicator.