For what it's worth, here's a chart showing the latest on the inverted yield curve, a condition where the yield on long-term bonds is lower than the yield on short-term bonds:
As you can see, the inverted yield has a perfect track record of predicting recessions over the past 50 years. However, it takes 1-2 years between the time the yield curve goes negative and the start of the recession.
So where does that leave us? It's been a little more than a year since our current inversion started. Also note that the current inversion is the deepest since 1980. This suggests a strong recession will start sometime toward the end of the year.
Or maybe not. The inverted yield has a good track record, but the pandemic has screwed everything up. Maybe this time it will finally fail.
I think “but the pandemic has screwed everything up” is a pretty good clause to use whenever trying to use historical data to look at what’s going on now.
I think there's another factor besides the pandemic that contravenes the conventional wisdom about the Yield Curve. That factor is the way conventional wisdom has flown out the window regarding the necessity of raising unemployment to counter inflation.
What's happening now is that inflation is decreasing *without* generally scuttling the economy. When you put that uncommon combination together, you get what ought to be a very satisfying picture of the future--optimistic anticipation of lower inflation AND a healthy economy. And what would that tell you to expect in the way of interest rates? Well, the one year rate has to correspond to the one-year inflation picture, while the ten year rate will correspond to the ten year expected inflation picture.
I think the inversion of the Yield Curve is a logical by-product of optimism about the future of the economy.
I think this is one piece of it.
I think another piece is that the Fed's interest rate setting has become decoupled from the fundamentals of the economy, if it was ever linked to the extent that previous orthodoxy and the Larry Summerses of the world would have had us believe.
I agree that the inversion of the curve is a result of everyone showing by way of their wallets that this "inflation" is transitory, and that the economy is fundamentally solid. Ergo, long-term optimism as you said.
"Also note that the current inversion is the deepest since 1980. This suggests a strong recession will start sometime toward the end of the year."
There is no relationship between the depth of the inversion and the severity of the recession in the chart you posted.
It is best to think of the yield curve, not as a direct forecast of the real economy, but rather as a readout of what bond investors are collectively forecasting. People are willing to accept lower yields on long bonds because they believe that the Fed will sharply cut interest rates in the not-too-distant future.
One reason for a Fed cut would certainly be a recession. But its not the only reason. Maybe the Fed will declare that inflation has been conquered, and that high short-term rates are simply no longer needed. Or maybe the bond traders are simply wrong about the future path of interest rates.
Time will tell.
Yea, the more I think about the yield curve the less I understand its usefulness.
It's essentially a summary of what bond traders are predicting given the freely available data that everyone is puzzling over. So by saying the inverted yield curve chart has some predictive power we're basically saying that bond traders have some magical power to predict every recession?
You are basing a ton of your conclusions on dumb luck.
10 year less 2 year is just one definition of inversion.
You are ignoring an inversion in the mid 90's. It did invert again but the first one must have forecast a very strong economy.
It also inverted in 2019. Maybe the yield curve was smart enough to predict Covid?
There was only a small inversion before the Great Recession.
Also you have a major problem that inverted yield curves don't do as good a job in other countries.
Overall, it has predicted about 8 of the last 5 recessions.
Your math is off a bit as summer 1998 is the only time that the yield curve has failed to predict a recession. You might be right about the current episode failing to predict a recession, but its clearly dishonest to count it as a failure at this point.
We know that following the 1998 inversion, the Fed immediately cut rates 3 times in rapid succession. Given the Feds quick and dramatic response on that occassion, its bizarre that you attribute the lack of a recession to 'dumb luck'.
Contrast with the 2000 amd 2007 episodes were the Fed waited 12-14 months after thr inversion before they began cutting rates.
This conversation and likely the chart above would be very different if the Fed were cutting rates or even holding steady. But they are not.
i'm checking revelations to see if an inverted yield curve is a sign of end times.
Jesus may save, but does he hedge?
It used to be that recessions and inflation happened when supply and demand got out of whack. There was too much demand for factories to meet then rates went up and demand crashed and factories slowed down till the supply and demand got in sync.
This time is crazier. During the pandemic companies just took the chance to raise prices that contributed largely to inflation. The Fed just has one tool which is to raise rates. They could try raising taxes on large profits but no way that will happen.
Also, I don’t know how to measure this but it seems that in the last decade or two companies have figured out how to use software to better manage scheduling. Maybe that is why things are rolling along now in spite of higher rates.
I think that currently most of the inverted yield curve is due either to (a) entities essentially forced to invest in long duration debt or (b) bond market idiocy.
The Fed has made abundantly clear that it wants to keep inflation close to 2% annually. This pretty much puts a hard floor on short term interest rates at 3% ... and more reasonable expectations of future short term interest rates closer to 4% if not higher.
Other than entities essentially forced to invest in long duration debt, long duration debt has to compete with keeping money in cash or short duration debt: why lock your money in at 3.875% for 10 years or 4.125% for 30 years if you can get 5.511% interest on a 6 month Treasury bill -- or around 5% on cash -- and then see if better rates aren't available in the future?
Now, there should be some sort of risk adjustment, one way or the other, for long duration debt versus short duration debt or cash: if you lock yourself in for 10 years at 3.875% and 10 year and shorter rates go up to 5% or higher, you lose; contrarily, if rates drop down to 2% or lower, you win.
But the thing is, there is an EXTREMELY hard floor on interest rates at 0% ... but even with a monetary authority committed to maintaining stable interest rates and inflation, there is no absolute ceiling.
Future interest rates are often modeled with a lognormal distribution, which sort of meant that the likelihood of rates halving is roughly equivalent to the likelihood that they will double.
And if 10 year interest rates go from 3.875% to 1.9375%, the value of a payment of $100 in 10 years goes from about $68.37 to $87.24.
But if rates go from 3.875% to 7.75%, the value of the same payment goes to $47.41.
So a loss of $21 is about as likely as a gain of $19: is that really the situation you want to be in if you can get compensated by over 1% annually for just holding cash -- ?