Inverted yield curve still a good alert for recession

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Federal Reserve Bank of San Francisco
The Federal Reserve Bank of San Francisco said the curve is a powerful signal of a looming recession. -- WIKIPEDIA

AN INVERTED yield curve remains a powerful signal of a looming recession and that is still the case even if the current ultra-low level of US interest rates are taken into account, according to fresh research by the Federal Reserve Bank of San Francisco.

A negative curve, where the return to investors on shorter-dated securities is above that on longer-term bonds, has predicted all nine US recessions since 1955, with a lag of six to 24 months. Some have argued that this time is different, because interest rates are so low and a flattening yield curve doesn’t necessarily mean the US economic expansion is heading for trouble.

The findings, published Monday in the San Francisco Fed’s regular Economic Letter, show that the term spread, or the difference between short- and long-term interest rates, is as good today as it’s always been at spotting problems ahead. But there’s no urgency just yet. While relatively flat, the current yield curve doesn’t signal a high risk of a downturn even though the US economic expansion is already the third longest on record.

“Forecasting future economic developments is a tricky business, but the term spread has a strikingly accurate record for forecasting recessions,” study authors Michael Bauer and Thomas Mertens, who are both economists at the San Francisco Fed, wrote in their analysis. “While the current environment appears unique compared with recent economic history, statistical evidence suggests that the signal in the term spread is not diminished.”

The spread between one-year and 10-year Treasury yields is roughly 0.8%. This is slightly higher than the 0.64% it touched in early January, but is well under its 15-year average of around 1.75%.

“As of February 2018, the estimated recession probability is 11%, which is elevated but comfortably below the critical threshold given that the term spread is not yet close to zero,” they wrote.

Economists arguing that the world has changed point to several factors to back up their thinking, including that a decline in the so-called neutral rate of interest — a theoretical level that neither speeds up nor slows down economic activity — means that a rise in short-term borrowing costs will slow the economy less than in the past.

The study’s authors looked into this by incorporating several other variables, including the neutral rate asset prices, into their computer models and found that these don’t improve on the recession-spotting abilities of a simple model that only uses the term spread.

“While these hypotheses have some intuitive appeal, our analysis shows that they are not substantiated by a statistical analysis that incorporates the suggested factors into the type of predictive models we use,” they wrote. “An extensive analysis of various models leads us to conclude that the term spread is by far the most reliable predictor of recessions.” — Bloomberg