The recent inversion of the US yield curve has seen many interpreting this as the harbinger of a recession in 2020. Though such an inversion is a sign that investors should be wary, the evidence from the last four recessions in the US suggests that investors should not be panicking.
Measuring yield curve inversion
Interpreting yield curve inversion is somewhat complicated by there being several approaches to quantifying the slope of the yield curve. For simplicity it is useful to consider the slope of the yield curve as being measured based on either a Contemporary or Prospective basis. The basis the yield curve is being measured on will depend on the interest rate utilised as the short-term reference rate within the calculation. The distinction between the two approaches are:
- Contemporary yield curves use the current cash rate (calculations in Figure 1 use the official overnight cash rate) and therefore only considers the current stance of monetary policy.
- Prospective yield curves use longer dated interest rates (calculations in Figure 1 use the 2 year government bond rate) and thereby incorporate a forward looking perspective of what the market expects the cash rate to be going forward.
The key distinction between the utilisation of different shorter-term reference rates is that the Prospective yield curve incorporates the central bank’s expected reaction function going forward whereas the Contemporary yield curve doesn’t.
Do inverted yield curves predict recessions?
The difference between Prospective and Contemporary yield curves may appear subtle, however history suggests that it is important to consider both when trying to interpret the significance of yield curve inversion as a predictor of recessions. This is illustrated in Figure 1, which plots both Contemporary and Prospective measures of yield curves along with recessions as defined by the National Bureau of Economic Research (‘NBER’).
Using monthly data from January 1980 to June 2019 highlights that each of the four recessions from 1981 have been preceded by yield curve inversion. But an equally important point to note is that prior to each recession both the Contemporary and Prospective measures of yield curves inverted. By contrast when there is a disconnect, the Contemporary yield curve inverts but the Prospective yield curve doesn’t, inversion of the Contemporary yield curve has tended to give a false signal with respect to signalling a recession (yellow circled areas in Figure 1).
What the Fed is intending to do with cash rates post inversion is just as important as the inversion itself
The false signals given by the disconnect between the two yield curve measures illustrates how the outlook for the direction of cash rates is just as important as the yield curve inversion itself when signalling a recession. The reason for this would appear to be that recessions from the 1980s onwards have been ‘brought on’ by the US Federal Reserve (‘Fed’) wanting to slow the economy; i.e. they occurred due to Fed action not despite it. Inversion was brought about by the Fed raising cash rates, and more importantly continuing to increase cash rates post inversion as they have sought to manage inflation risks. To demonstrate this more clearly Figure 2 records recession dates but more importantly the cash rate one month prior to yield curve inversion as well as the peak of the cash rate post initial inversion.
What is worth noting is that in each of the recessions since 1980 the cash rate continued to rise post the initial inversion; i.e. the US Federal Reserve continued tightening monetary policy after the yield curve inverted. Ignoring the recession of 7/1981-11/1982, the average increase in the cash rate post initial inversion has been around 100bps. It is because of this expectation that the Fed will continue raising cash rates that both the Contemporary and Prospective yield curves invert.
By contrast the false signals with respect to the Contemporary yield curve (those inversions unconfirmed by the Prospective yield curve) arise when the Fed is cutting rates (see Figure 3).
The forward-looking nature of the Prospective yield curve doesn’t confirm the inversion of the Contemporary yield curve as the market is expecting a more accommodating outlook from the Fed. The Fed is expected to lower rates to offset the current economic weakness and the result is that inversion of the Contemporary yield curve is less likely to be associated with a recession.
What does recent history indicate about interpreting yield curve inversion and recessions?
The historical experience post the 1970’s has highlighted that there are several conditions necessary to interpret the inversion of the yield curve as signalling a recession.
Firstly, both the Contemporary and Prospective measures of yield curves should invert.
Secondly, this will generally only occur when it is anticipated that the Fed will continue to raise rates post the inversion of the yield curve.
In practice recent history suggests that an investor would need to see both conditions satisfied before being confident that the inversion of the yield curve is indeed signalling that a recession is imminent.
For now, fighting inflation was yesterday’s battle
The flatter yield curve is a cause for concern, at this stage it doesn’t yet satisfy the criteria to be deemed as signalling that a recession is imminent. With central banks globally becoming more concerned about how to increase, rather than decrease, inflation a more ‘dovish’ bias to setting interest rates appears to have been adopted to extend the economic cycle. Against such a backdrop the idea of the Fed aggressively raising rates to ‘bring on’ an economic slowdown would appear less likely. This is not to say that an exogenous shock can’t derail economic growth in the US and thereby generate a recession. A more pro-growth Fed, coupled with a greater tolerance for higher inflation, reduces the risk that they will fail to adopt policies to forestall such a risk. As central banks shift from seeing the main risk as higher inflation to it being slower economic growth, it’s not surprising that the Contemporary and Prospective yields curves are not providing a confirming recessionary signal. It may pay investors to be wary but concluding that the inversion of the Contemporary yield curve is signalling a recession may be premature.