Why a Recession Could Arrive Without a Yield Curve Warning
February 06 2016 - 5:59AM
Dow Jones News
By Ben Eisen
Investors may not be able to count on a once-reliable economic
warning bell to ring before the next recession.
Before every one of the past seven U.S. recessions, long-term
interest rates fell below short-term rates, producing what
economists call a yield curve inversion. Historically, the slope of
the yield curve has been such a reliable predictor of economic
conditions that economists at New York and Cleveland Federal
Reserve banks use it to calculate the probability of recession.
Ultralow yields on short-term bonds, however, may prevent the
yield curve from inverting even if the economy is about to
contract.
The yield curve is a graph of interest rates arranged in order
of bond maturities. Normally, it slopes upward because long-term
interest rates are higher than short-term rates to compensate
investors for accepting increased risk. Long-term bond yields are
thought to reflect the average of future short-term interest rates
expected over the life of the bond plus this so-called term
premium.
When the yield curve steepens, it usually reflects expectations
of higher short-term rates in the future, signaling economic
growth. A flattening curve indicates expectations that rates will
tumble. That typically happens because the market anticipates the
Federal Reserve will ease monetary policy to stimulate a slowing
economy. An inverted yield curve implies the market expects
short-term rates to fall sharply and stay persistently low,
signaling an economic contraction.
The difference between yields on 3-month Treasury bills and
10-year notes is regarded by economists at the Fed as the best
yield curve predictor of recessions. This is currently at 1.54
percentage points, according to Tradeweb. That is down roughly half
a percentage point since the end of last year, but remains wide by
historical standards. By the New York Fed's calculation, this means
there is less than a 5% chance of a recession in 12 months. The
Cleveland Fed puts the chances slightly higher, at 6.19%.
But with short-term rates already so low, long-term rates would
have to go very close to zero for the yield curve to invert. Since
that seems highly unlikely, the inversion indicator may be
broken.
Some investors and analysts believe the slope remains positive
only because of extensive central bank easing, which tends to push
harder on short-term rates.
Mark Yusko, chief executive of Morgan Creek Capital Management,
said last week that he believes the curve would already be inverted
if not for the relentless pressure on short-term rates.
"Historically, it has been a predictor," said Gemma
Wright-Casparius, a senior portfolio manager at Vanguard. "We are
looking to other factors at this juncture."
Not everyone is convinced. Banks including Royal Bank of Canada
and UBS Group AG have pointed to the yield curve amid the market
turbulence to dispel fears of a coming recession.
Japan's experience with ultralow rates may be instructive.
During each of its past four recessions, the yield curve didn't
invert. Analysts at Deutsche Bank AG argue this indicates the yield
curve won't invert when short-term rates are below 1%.
But even if the curve won't invert before a recession,
differences between long and short interest rates still could help
predict economic conditions. For example, the U.S. yield curve has
been flattening in a similar manner to Japan's before it entered
recent recessions, said Joseph LaVorgna, chief U.S. economist at
Deutsche Bank.
"To me, the yield curve is sending the unmistakable signal that
growth is not getting better," he said.
(END) Dow Jones Newswires
February 06, 2016 05:44 ET (10:44 GMT)
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