The Yield Curve as Recession Predictor…

Economists and policy makers are spending a lot of time talking about the yield curve these days. This bond market metric plots the yields investors receive for different maturity bonds. Because they demand more compensation for holding longer-term debt, the yield curve typically slopes upward to the right (see chart below ). On rare occasions, however, the curve inverts and longer-term maturities offer lower yields than shorter-term maturities.

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So why should we care about a bunch of lines on a graph? The yield curve recently inverted, a development that occurred just prior to 9 of the past 10 economic downturns. The lag time between the yield curve inversion and the actual onset of recession ranged from 8-20 months with an average time of one year. To understand why the yield curve might have predictive powers consider that prevailing interest rates are actually a reflection of millions of investors’ views. When these investors expect the Federal Reserve to lower rates in reaction to a slowing economy, they flood into higher yielding long-term debt. This increased demand drives down long-term yields relative to short-term yields.

Several economists, however, are now suggesting that the outlook may not be as bad as it seems. More specifically, they claim that the increased demand for long-term Treasury debt comes not from investors’ fears of recession but from other recent developments in the bond market. To meet post-crisis regulatory requirements, banks have had to boost their reserves of ultra safe assets like Treasuries. Meanwhile, insurance companies and pension plans looking to reduce funding risk have also soaked up long dated bonds. Finally, the U.S. government may be playing a role. The U.S. Treasury finances most of its growing budget deficit by issuing short-term debt. This increased supply is likely driving up short-term relative to long-term rates.

Before you breathe a sigh of relief, consider the possibility that the yield curve may be less a predictor of recessions than a cause of them. The reasoning here is pretty straightforward. Banks fund their lending activity with short-term borrowings. When these funding costs go above what they can earn on long-term loans, lending dries up and with it general economic activity. Further, businesses may react to yield curve inversions by cutting back capital spending and other investment plans.

While the yield curve’s inversion can’t be viewed as a positive, investors should take a deep breath before running for the exits. First, measures of the “real” economy like unemployment and consumer confidence are holding up pretty nicely and research has shown that when the yield curve is flashing red and the real economy is doing well, it’s best to pay attention to the real economy. Second, economic predictions are notoriously bad (consider that most economists failed to see the global financial crisis coming).

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Unfortunately, we cannot know with any accuracy when the next recession will hit. But if history holds, when it arrives it will be neither fatal nor permanent. How to prepare? Make sure your current mix of bonds, stocks and cash is in line with your overall tolerance for risk. And don’t forget to hold sufficient cash to cover short-term (3-12 months) spending needs. In a down market, nothing soothes the nerves like cold, hard cash.