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Did the Yield Curve Send a “False Alarm?”

Posted By Barry Ritholtz On April 12, 2006 @ 7:05 am In Data Analysis,Economy,Federal Reserve,Fixed Income/Interest Rates,Inflation,Investing,Markets | Comments Disabled

"So much for the inverted yield curve."

Or so says a recent Bloomberg column [1]. If I read this correctly, any inversion that fails to cause an immediate recession is proof positive that inversions are meaningless, the bond market clueless, and data analysis of little if any value. Therefore, as an economic indicator, this must be declared null and void and immediately disposed of.

To wit:

"Bond yields may have sent a false alarm. The government said today that U.S. employers added 211,000 jobs in March, capping the best start for hiring of any year since 2000. Gross domestic product last quarter probably expanded at a 4.7 percent rate, the fastest in more than two years, a Bloomberg News survey shows. The Federal Reserve is talking about the need to keep raising interest rates to make sure the economy doesn’t overheat."

Let’s reiterate some of our prior comments about the yield curve, and what it means for investors:

First, any serious student of the market needs to consider the depth and duration of the inversion [2]; That impacts what it implies for the future. As we wrote last year [3]:

"A brief, shallow inversion won’t signal any marked slowdown in the economy.

Over the past several decades, the yield curve has had to invert by two percentage points or more before a recession materialized."

The longer and more inverted an inversion is, the greater the slowdown it forecasts. A short, shallow inversion is a warning; The longer it stays inverted, the greater the impact. There is a nuance to the curve that seems to be getting overlooked.

Second, Yield curves do not take place in a vaccuum. The context and other factors [4] involved need also to be considered, such as energy prices. And to reiterate this yet again,  one needs to consider at all times multiple variables when analyzing Markets [5]. The context of rising oil prices and inversions is important (see the charts here [4] for more).   

Its worth pointing out that the yield curve is actually more than one variable; its a combination of two factors:

First, Short interest rates, which reveal the Central Bank’s economic expectations.

And, second, its a function of long rates, which embodies the Bond Market’s economic expectations.

As we quoted in December [6]:

"The historical record speaks for itself," said Merrill Lynch analysts in a report published Friday.

"In the past 30 years, the yield curve has inverted five out of the eight times the Fed has been tightening monetary policy. Each of those five times an economic recession has ensued one year later — our fear (though not our base case) is that this time will be no different."    – Marketwatch [7]

That’s a year later — not 90 days. If you want to be even more precise, the historic lead time is 40 weeks [3] prior to a slowdown.

Lastly, consider this chart:
(previously shown in September ’05 [8])

click for larger graphic

Yield_curve_fed_tighten_1_1 [9]

The data looks fairly persuasive that any inversion is worth noticing, and that a longer deeper one is a broad warning sign that investors ignore at their own peril.

Yes, we live in a bumper sticker society, where nuanced is scorned, sound bites rule, and careful contemplation is a rarity. That doesn’t mean we all have to succumb to the philistines . . . 



Yield Curve Sent False Alarm as U.S. Economy Expands

Elizabeth Stanton
Bloomberg, April 7, 2006 09:44

Understanding the Inverted Yield Curve [10]
August 20, 2005

Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2006/04/did-the-yield-curve-send-a-false-alarm/

URLs in this post:

[1] Bloomberg column: http://www.bloomberg.com/apps/news?pid=10000087&sid=a5u6EZ2BqstY&refer=top_world_news

[2] depth and duration of the inversion: http://bigpicture.typepad.com/comments/2005/12/inverted_yield_.html

[3] last year: http://bigpicture.typepad.com/comments/2005/12/a_study_on_the_.html

[4] context and other factors: http://bigpicture.typepad.com/comments/2005/08/recession_predi.html

[5] multiple variables when analyzing Markets: http://bigpicture.typepad.com/comments/2005/05/single_vs_multi.html

[6] December: http://bigpicture.typepad.com/comments/2005/12/explaining_yile.html

[7] Marketwatch: http://www.marketwatch.com/news/yhoo/story.asp?guid={9AAEBA23-827C-42F9-8B41-6F4BCF728F75}&siteid=myyahoo&dist=myyahoo

[8] September ’05: http://bigpicture.typepad.com/comments/2004/09/flattening_yiel.html

[9] Image: http://bigpicture.typepad.com/.shared/image.html?/photos/uncategorized/yield_curve_fed_tighten_1_1.jpg

[10] Understanding the Inverted Yield Curve: http://bigpicture.typepad.com/comments/2005/08/understanding_t.html

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