From a small northwestern observatory…

There has been a good bit said lately about the yield curve inverting.  Historically, so they say, an inverted yield curve forecasts a recession.  I decided to explore that concept a bit.  Like all generalizations, this may have a grain of truth in it, but there is more than meets the eye.

By the way, this topic has been explored in greater depth, and with more granular data, by economists who actually focus on this topic.  (Just as a reminder, my area is Real Estate Securities).   If you are reading this with an eye to fleshing out some masters thesis somewhere, I’d suggest you keep looking for authorities.  That said, the FED leadership is meeting in Jackson Hole this weekend, and you can bet this is on the agenda.

Speaking of the FED, I grabbed a bit of data from them — monthly 10 year treasuries and 6 month bills back to December, 1958.  I actually explored some other time periods and even daily data, but this was the best pairing I could get in short order.  Anyway, the “shape” of the yield curve is essentially the gap between these longer term rates and the shorter term ones.  For a normal yield curve, the long bonds (10 year) should be about 2 to 4 percentage points above the short term yields.  That makes some intuitive sense — in “good times”, borrowers are willing to pay more to borrow longer term, and investors are willing to accept less return for shorter term loans.  When borrowers sense that there may be trouble ahead, they are less willing to borrow long-term, and hence the demand for long term money falls relative to short-term stuff.  When things go really topsy-turvy, the short-term money is actually more expensive than the longer term, because borrowers simply don’t want to borrow long-term at all.  The topic is w-a-a-a-a-y more complex than this, but hopefully you get the picture.

Speaking of pictures, I then took the difference between these two yields and graphed it.  Along with that, I graphed the incidence of all of the recessions since 1958.  Here’s what I got:

Data courtesy Federal Reserve, graphic (c) Greenfield Advisors, Inc.

Not EVERY inversion was followed immediately by a recession. although almost all were.  The only exception was in 1966.  That one is generally considered a “false positive” because it was triggered not by general economic trends but by a short-term reduction in Federal spending.

More interestingly, though, is the long-term bull market of the 1980’s, which was followed by the recession of 1991.  That long-term market followed the double-dip recessions of 1980 and 81, which are often considered one long recession.  (I know — I was there.)  More to the point, the recession of 1991 was not following a yield curve inversion.  Indeed, the yield curve spread, measured on a monthly basis, never got below 0.38%, in November, 1989.  Also, notably, the behavior of the yield curve over the course of the 1980’s mimics what we’ve been seeing of late.

There is also an argument that rates are behaving more like the 1992-2000 period, and there is some rationale for that.  If that’s the case, then the question is whether the yield curve recovers from here or takes a swan dive below zero. If the former, then we may have 2 years or so of continued positive GDP. If the latter, then we’re headed for a rough patch.

The yield curve spread ended July at 0.78%, and closed yesterday down at 0.59%. Again, this is the data the FED leadership is discussing in Jackson Hole.  We’ll keep you posted.