- Barron’s – Campbell Harvey: What the Yield Curve Inversion Really Means, According to the Professor Who Discovered It
I have been analyzing the yield curve for more than 30 years—my 1986 dissertation at the University of Chicago showed that an inverted yield curve, where short-term rates are higher than long-term rates, led to a recession within 12 to 18 months. Since then, what researchers call “out-of-sample evidence” has validated my model. Since the publication of my dissertation, the model is 3 out of 3. There have been no false signals to date. The joke that an indicator has forecast 11 of the last three recessions does not apply here. - The Wall Street Journal – James Mackintosh: Inverted Yield Curve Is Telling Investors What They Already Know
Long-term bond yields plunging below short-term ones is a good predictor of Fed rate cuts and an economic slowdown—but a recession is no guarantee
Since the 10-year discounts the average short rate over the period, that should mean the 10-year falls. That isn’t quite the same thing as predicting recession, since the Fed can cut rates without recession. Indeed, the two times that yield curves inverted on most measures without recession were in 1998 and 1965-66, both times when the Fed slashed rates and the economy continued to grow…the bond market has changed with quantitative easing, making inversion much easier. Before QE there was usually some extra yield, known as the term premium, built into 10-year Treasurys as compensation for locking your money up for so long. That meant that to get to an inversion, investors had to expect really significant cuts, which rarely happen without recession. But in recent years the term premium has been nonexistent or negative, so the gap between the 10-year and three-month yield was lower to start with. Even anticipation of quite small cuts can make the curve invert.
Summary
Comment
We agree with the highlighted passage above that we are in a new QE regime. That said, we do not think that means the yield curve lost its effectiveness as an economic indicator. The yield curve appears to be acting as it has in every other cycle.
As we have noted previously, inversions typically occur via a bull flattener. A bull flattener occurs when the market believes monetary policy is too restrictive. Long rates fall on the belief that the the economy is weakening. At the same time, the Fed is holding up the short end of the curve due to inflation concerns. These dynamics can be seen in the chart above.
To be clear about defining an inversion, we only consider cases when the 10-year less 3-month curve has been inverted for at least 10 consecutive days. There are instances when an inversion occurs for very brief moments that are not as indicative of a recession (Sep 1998, Apr 2000 and February 2006 are noted on the chart below).
This is an observable way to say the curve is inverted and is going to stay that way. Campbell Harvey’s seminal 1986 Ph.D. dissertation (and here) looked at the 5-year/3-month yield curve in a similar way. He found this was a good leading indicator of a recession. Again, when the yield curve is persistently inverted, it is saying the Fed is too tight. The sooner they stop being too restrictive, the better.
If the Fed realizes its mistake soon enough, the curve inversion can last a short period of time. See the July 1989 period above when the Fed began cutting rates quickly on the heels of inversion. Because they acted so quickly in this case, the recession did not hit for a long time after the first cut.
On the other hand, when the Fed is slow to change course in the face of an inversion (December 2000 or September 2007), the economic damage is far greater. Because cuts come later in the cycle, the recession follows very shortly after the first cuts.
Assuming this yield curve inversion lasts at least 10 consecutive days, all eyes will be on the Fed to see how quickly they react.
- Tim Duy’s Fed Watch – Fed Needs to Get With The Program
My interpretation of this new inflation realization is that the Fed has a fairly low bar for a rate cut…the Fed needs to get with the program and cut rates sooner than later if they want to extend this expansion. Given inflation weakness and proximity to the lower bound, the Fed should err on the side of caution and cut rates now. Take out the insurance policy. It’s cheap. - The Wall Street Journal – Fed’s Harker Says Central Bank May Raise Rates This Year Despite Risks
Philadelphia Fed leader Patrick Harker said Monday the central bank may yet raise rates this year even as risks around the outlook have risen. The U.S. economic outlook is “pretty good,” Mr. Harker said in the text of a speech to be delivered in London. But, “on balance, the potential risks tilt very slightly to the downside, but I emphasize the word ‘slight,’” the official said. Despite his concern, Mr. Harker said he is largely sticking to his outlook for monetary policy. “I continue to be in wait-and-see mode,” he said. But he added, “my current view is that, at most, one rate hike this year, and one in 2020, is appropriate, and my stance will be guided by data as they come in and events as they unfold.”
- The Wall Street Journal – Chicago Fed President Evans Doesn’t See Rate Rise Until Second Half of 2020
Chicago Fed President Charles Evans said Monday that he doesn’t expect an interest-rate increase in the U.S. until next year, probably in the second half. … The U.S. economy remains in a strong position, he said, forecasting growth of 1.75% to 2% this year, down from his last estimate of 2019 growth at 2.25%. He also noted that the Fed’s target for benchmark rates of 2.25% to 2.5% is “close to neutral” and that U.S. monetary policy is providing neither significant accommodation nor is it restraining the economy. “It’s a good time to stop, pause, look and see how things are going to progress and be cautious,” he said Monday.
Harker and Evans are still looking for the next time to hike rates. This is how recessions are created.
We agree with Tim Duy that the Fed should get serious about cutting rates. The market believes the same. As the next chart and table show, the market is now expecting a cut in rates later this year.
Conclusion