(Bloomberg Opinion) -- Can the Federal Reserve end the U.S. Treasury market yield curve’s track record for predicting recessions? If so, market participants using the gap between short- and long term bond rates to gauge the economic cycle might be overestimating the probability of recession.
I have long been a fan of the yield curve as one tool to track the economy, and it is sending unwelcome signals this year. Yields on 10-year notes fell below those on two-year notes on Wednesday for the first time since 2007. Another portion of the yield curve, the spread between three-month bill rates and 10-year yields, which is the favored recession signal for the economists at the Federal Reserve Bank of San Francisco, has been inverted since May. It’s no wonder that market participants are increasingly concerned with the economic outlook.
Historically, whenever the spread between two- and 10-year yields inverts, a recession follows six to 24 months later. The Fed, though, typically ignores this signal because inversions happen well ahead of a downturn and when the Fed is more worried about inflation than recession. Also, an inversion was often the only sign of recession. In fact, the Fed has often continued to raise policy rates after an inversion. That sequence of events – the Fed tightening after the yield curve inverts – tends to precede a recession.
The Fed is taking a very different approach in this cycle. More policy makers seem to view an inverted curve as signaling economic weakness. From the minutes of the June Federal Open Market Committee meeting:
“Many participants noted that the spread between the 10-year and 3-month Treasury yields was now negative, and several noted that their assessment of the risk of a slowing in the economic expansion had increased based on either the shape of the yield curve or other financial and economic indicators.”
As further evidence, the Fed has already cut rates well ahead of broad-based recessionary signals. Although, according to central officials, the economy is in a “good place,” they are not waiting until the data turns decisively toward weakness before easing policy.
In this cycle, low rates of inflation leave the Fed more concerned about downside risks to the economy, particularly those stemming from weak global growth and the Trump administration’s chaotic trade policies. This setup will help minimize the odds of recession and reduces the recessionary signal from the yield curve.
The upshot is that the yield curve has been a good predictor of a recession in part because the Fed did not believe it had any special significance. Once the Fed finds significance in the yield curve, then its usefulness as a recession predictor likely drops sharply. In addition, downside risks to the economy have already forced the Fed to loosen policy, and more rate cuts are coming. The Fed will lower its target for the federal funds rate again in September, and a 50-basis-point cut can’t be ruled out.
Will the Fed be able to sustain the expansion? That is still an open question; policy makers still may not move quickly enough, especially if the trade shocks keep coming. But assuming the U.S. skirts a recession, the Fed, in the process of trying to kill your recession call, may also kill the yield curve as a recession indicator.
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Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
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