There is much talk about whether the predictive powers of the yield curve are waning, with a growing number of experts arguing its inversion no longer signals recession. “This time it’s different,” they say.
Those four words may turn out to be prophetic – but they should still set alarm bells ringing for policy-makers, economists and financial market professionals, who consistently fail to call the next recession.
The yield curve, meanwhile, has been calling them right for 45 years.
The debate is heating up because the U.S. economic expansion, entering its 10th year, is close to becoming the longest in history. It can’t be too far away from rolling over, and the yield curve is inching ever closer to inversion.
A shrinking gap between long- and short-dated yields suggests investors expect slower economic growth further out, higher interest rates in the near term to keep inflation in check, or limited rate hikes further out due to softening inflation pressures. Or a mix of all of the above.
An inverted curve, where long-dated yields are lower than short-dated ones, points to the Fed being forced to cut rates in the future. All five U.S. recessions since the 1970s have been preceded by an inverted curve.
The gap between two- and 10-year yields, the benchmark curve, is the flattest it’s been for 11 years and just 26 basis points away from inverting.
Why might things be different this time?
In a world where yields on large swathes of the European and Japanese sovereign bond markets are still negative, U.S. Treasuries are effectively high-yielding securities. Demand for 10-year paper at around 3 per cent, in what’s perceived as the most liquid and safest market in the world, is huge.
Yields are also being compressed by the Fed’s bloated, crisis-fighting balance sheet. It’s being reduced ever so slowly, but the $4 trillion of bonds on the central bank’s books is still enough to cap any rise in 10-year yields.
Inflation has remained stubbornly low since the crisis and the second longest U.S. expansion in history hasn’t led to significant wage growth. Many say traditional relationships between growth and inflation have broken down thanks to technology, weak labour bargaining power, a more flexible labour market and the “gig economy.”
So much so, the Fed is scouring new niches of the financial markets to find signals accurate enough to warn it when it needs to stop hiking interest rates before they risk tipping the economy into recession.
One indicator they and others might want to look at is the Philly Fed’s “Anxious Index,” which measures the probability of GDP contraction in the next quarter. It’s historically low right now, near levels that have preceded every recession in the past half century.
Joe Lavorgna, chief U.S. economist at Natixis, says economists and market participants need to take a “holistic” approach to forecasting – paying attention to leading indicators like housing permits and the yield curve – or they will miss the next recession. Again.
One assumes the IMF does this, and its semi-annual World Economic Outlooks have morphed over the years into something of a global economic forecasting benchmark. But the IMF’s track record here is patchy at best, and is worth noting.
The last two U.S. recessions were March 2001-November 2001 and December 2007-June 2009. The first was light and relatively short-lived, the second was one of the most savage ever.
In its WEO from September 2000, the IMF predicted global growth of 4.7 pct in 2000 slowing only slightly to 4.2 pct in 2001. “The outlook for the global economy has continued to strengthen, with GDP growth projected to increase in all major regions of the world,” notably the United States.
In its WEO from October 2007, just two months before the economy peaked then went into recession, the IMF said: “In advanced economies, deep recessions have virtually disappeared in the post–World War II period.”
The financial crisis began to factor into forecasts as 2008 unfolded, but the WEO in January that year still projected 4.9 pct global growth in 2007 and 4.1 pct in 2008. The October 2008 WEO noted that “many advanced economies are close to or moving into recession,” but the IMF still pencilled in 3.9 pct global growth that year.
Events turned out rather differently.
Given its past accuracy and the lack of alternatives, the yield curve is one of the few recession-forecasting tools economists have. Maybe it won’t be different this time after all.