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The US yield curve is not a broken recession indicator

By Robin Marshall, director of fixed income research

The recent inversion of various parts of the US yield curve has revived concerns that this inversion is—as night follows day—a definitive recession omen. More recently, it has been suggested that the relationship between yield curve inversion and recession is obsolete.

The assertion that an inverted yield curve—presumably 10-year vs. 2-year yields—is a “broken barometer" of recession risks appears to be based on two propositions. First, the view that the Fed’s post-2009 quantitative easing programs have distorted the yield curve, rendering it flatter relative to previous cycles. But given how reliable the US yield curve has been in forecasting previous US recessions—inverting with a lead time of 12-18 months before each of the last eight US recessions in 10-year/2-year—ignoring a full yield curve inversion as a US recession indicator would require compelling counter evidence. 

Also, if a full yield curve inversion is defined to include 30-year/2-year inverting as well as 10-year/2-year and 5-year/2-year, all US recessions since the 1960s have followed within 12-18 months of a full yield curve inversion. More specifically, the widely quoted “false signal” of 1998 was only a partial yield curve inversion, since the 30-year/2-year did not invert. In this current cycle, the 30-year/2-year area has not yet inverted, though the difference in yield is now only 42 basis points.

There are technical reasons for thinking the 10-year/2-year section of the yield curve may be flatter in this cycle, mainly because the Fed is not actively managing the duration risk of its mortgage-backed securities portfolio. But the 5-year/2-year section of the yield curve has also inverted, which is a “cleaner" measure of recession risks, and normally inverts in advance of the 10-year/2-year, and 30-year/2-year (see Chart 1).

Chart 1: US yield curve and previous US recessions

Source: Datastream as of May 10, 2019. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

The second suggestion is that we are seeing a replay of the late 1990s' Asia Financial Crisis, when there was a "false signal" from the US yield curve, but there appear to be few obvious similarities between the current cycle and when that so-called “false signal" occurred. Growth in the US was much stronger back in 1998-99—nominal GDP grew at 6.9% when the Fed first eased in Q3 1998 and the Greenspan Fed reduced interest rates following the collapse of Long Term Capital Management (LTCM) and the Asian financial shock—compared to 3.84% in Q1 2019. And bond yields were also much higher back then, with nominal and real yields at 5.5% and 3.5% in the 10-year area before the LTCM and Asian shocks compared to the current 2.42% nominal and 0.54% real yields.

The reasons behind the Fed policy shift are quite different. In 1998-99, the Fed eased by 75 basis points in response to perceived systemic risk that never materialized. In 2018-19, the Fed has pivoted to neutral policy in response to growth headwinds and persistent low inflation. The US economy has also been in a lower nominal GDP growth regime since 2009 (see Chart 2) compared to the late-1990s. And US real and interest rates have been falling steadily since October 2018, whereas they barely fell at all in 1998-99.

Chart 2 US nominal GDP growth and 10 year US Treasury yield

Source: Datastream as of May 10, 2019. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

Canadian evidence casts doubt on view QE has been the main driver of US yield curve

Canadian yield curve evidence is also revealing. It is well known the Canadian economy is highly correlated with the US, because 75% of Canadian exports go to the US, so monetary policy settings are often similar. However, unlike the US, although the Bank of Canada (BoC) did supply "exceptional liquidity" to the financial system through term loan facilities, the BoC did not undertake QE purchases of government bonds during and after the GFC. So if QE purchases suppressed US Treasury yields and flattened the US yield curve, it should not have distorted or flattened the Canadian yield curve. At the very most, there might have been a gravitational pull from lower US Treasury yields.

But the Canadian yield curve has, indeed, inverted in 5-year/2-year, like the US in 2018-19. In addition, like other dollar-bloc alternatives to US Treasuries, Canadian government bonds now trade on lower yields than the US (see Chart 3). So Canadian evidence shows yield curves can invert without QE purchases, and outright yields decline for other reasons (low inflation, declining term premium, much lower nominal GDP growth regime, etc).

Chart 3: Canadian 10 year yields versus US Treasury 10 year yields

Source: FTSE Russell as of May 10 2019. Past data is no indication of future events. Please see the end for important legal disclosures.

This suggests QE may not have been the main driver of the flattening in the US yield curve, and that it may be unwise to dismiss the US yield curve as a recession forecaster, particularly if the 30-year/2-year section of the US curve follows the signal from the shorter maturities.

 

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