We have discussed the impact of an inverted yield curve repeatedly in the past. Much of the mainstream has denigrated the historical record of using this relative unusual relationship between yields as an indicator. They have strained credulity to somehow reach the conclusion that it really is different this time.

From Birinyi Associates, here is the recent track record of what they call "Intentional curve inversions:"
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Intentional_inversions

Source: Ticker Sense

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This seems pretty conclusive that there is a correlationn between the shape of the curve and subsequent recessions.

And these tidbits from Jim Stack of Investech Research agrees. He points out:

• The flat yield curve shows an 88% probability of a recession beginning sometime between now and the end of next year.

• The yield on the 10-year Treasury Bond hit new 4-year highs this week.

• Even excluding energy, the CRB Spot Raw Materials Price Index is showing the highest 4-year inflation
rate in 25 years.

• Of the past 10 tightening cycles by the Fed, only 2 resulted in a soft landing (without recession).

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Sources:
Intentional Inversions    
June 30, 2006   
http://tickersense.typepad.com/ticker_sense/2006/06/intentional_inv.html

Neutralizing risk
Jim Stack
Vol06 Iss08
Technical and Monetary Investment Analysis
Investech Research, June 30, 2006

Category: Data Analysis, Economy, Federal Reserve, Fixed Income/Interest Rates, Markets

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

30 Responses to “Ignore Inverted/Flat Yield Curve at Your Own Risk”

  1. LB says:

    The above chart says there is a good chance that a recession is on the way, but it doesn’t really show when. According to the chart, it could be right away or a few years from now.

    Best,

    LB

  2. grodge says:

    For LB, I wonder how much of the lag depends on fed policy regarding hawkishness on inflation.

    A delay in “removing the punch bowl” may delay eventual recession. Currently, we’ve had 17 or so tightenings in a row, so recession risk seems to be higher.

    I’m not sure if my reasoning makes sense.

  3. MH says:

    Without have seen the details behind their calculations, I’m pretty skeptical. Generally it is not easy to calculate a reliable correlation and probability on only a handful of events, since these depend on the law of large numbers (not the “law of small numbers”). After all, there could (by chance) be numerous of other events triggering past recessions (more likely multiple events as opposed to a single event).

    (For the record, I am a pessimist on the 12 month outlook, but not because of this study)

  4. drey says:

    According to John Mauldin, yield curve inversion precedes recession by a year or less approximately 80% of the time and I doubt this time will be any different…

    The question in my mind is, does the clock start running now, or did it start running when we had that brief inversion several months ago?

  5. RB says:

    Based on this Fed model
    http://politicalcalculations.blogspot.com/2006/04/reckoning-odds-of-recession.html

    the probability of recession is 33%. The record over the past 41 years is that there has always been a recession when the probability exceeded 50% and never a recession when it was less than 50%. Apparently, the only reliable indicator is the spread between 3-month and the 10-yr bonds. While a slowdown is certain, it appears we are not decisively in recession territory yet.

  6. Ned Davis says:

    Ned Davis: “The conventional wisdom on Wall Street holds that as soon as the Fed quits tightening, the market is going to take off again. It did that in 1994-95 and in 1989. In those cases, we did not have an inverted yield curve. But in almost all other cases, the market went down after the Fed quit tightening because either we were headed into an earnings slowdown or we had some crisis.”

  7. Estragon says:

    Even accepting the correlation (which as HM points out, may be suspect), it’s a long road to causation as implied in the tidbit in the article above…”Of the past 10 tightening cycles by the Fed, only 2 *resulted* in a soft landing “. A better choice of words might be only 2 *were followed by* a soft landing.

    In my view, the shape of the yield curve, including the choice of the fed in setting short rates, is a reflection of the state of the economy more than a cause of it. Obviously, monetary policy affects the economy, but the structure of the economy drives monetary policy in the first place.

  8. V L says:

    The yield curve has accurately predicted economic slowdowns since 1960. The last time the yield curve inverted was in 2000 and predicted the U.S. recession of 2001.

    One reason that the yield curve inverts prior to an economic slowdown is that economic recessions tend to mean lower interest rates, both because of lower demand for borrowed funds as well as the fact that the Fed is likely to lower rates aggressively in response to an economic downturn. According to the expectations hypothesis, to the extent that investors see this coming, the yield curve would start to slope down before the drop in economic activity.

    Since banks and securities firms borrow at short-term rates and lend out their money at long-term rates, an inverted yield curve is a good reason to stop lending money (compressed net interest margins).
    I am perplexed as to why would anybody buy bank stocks during the current inverted yield curve environment.

  9. Bruce Sherman says:

    VL posted:”Since banks and securities firms borrow at short-term rates and lend out their money at long-term rates, an inverted yield curve is a good reason to stop lending money (compressed net interest margins).
    I am perplexed as to why would anybody buy bank stocks during the current inverted yield curve environment.”

    This is my question too. Yet the big banks (e.g., BAC, C)have outperformed the market recently. I would also think that an almost certain slowdown–if not an outright recession–would not be good for bank stocks.

    Bruce Sherman

  10. V L says:

    RB-

    The link that you have provided contradicts your assertions.
    This is from the website:

    < < How likely is it that there will be a recession in the next 12 months? Well, now you can find out for yourself with Political Calculations' latest tool, which does the math developed by the Federal Reserve Board's Jonathan Wright in The Yield Curve and Predicting Recessions (HT: James Hamilton's Econbrowser, where the specific formulation used in the following tool was outlined).

    As for James Hamilton's assessment of the Fed's recession predicting model:
    “... if we accept Model B at face value, a couple more 25-basis point bumps by the Fed would put the funds rate at 5.25% and likely push the spread into negative territory. From the table above, that starts to make a recession look like a pretty good possibility.” >>

  11. RB says:

    VL,
    At 5.25% the spread has to be -0.44 for 50% probability of recession as given here:
    http://politicalcalculations.blogspot.com/2006/06/visualizing-probability-of-recession.html

    (Credit to Calculated risk for putting up these links)

  12. Estragon says:

    VL / Bruce Sherman – “This is my question too. Yet the big banks (e.g., BAC, C)have outperformed the market recently. I would also think that an almost certain slowdown–if not an outright recession–would not be good for bank stocks”

    I think we’re in somewhat uncharted territory here. I don’t think it’s necessarily accurate to state unconditionally that banks borrow at short term rates to lend at long term rates. They can and do lay off interest rate, duration, and credit risks through derivatives and securitization, so it’s not entirely clear exactly where these risks are borne.

    Maybe part of the reason BAC & C are able to outperform is that they’re in a position to more accurately assess (and price) those risks than those taking the other side of the derivatives trade. If so, a slowdown isn’t necessarily bad for banks, provided they can continue pricing the risks better than their counterparties.

  13. me says:

    The denial always amazes me. The housing bubble is starting out like a tub full of water spiraling down the drain. Slowly at first and then look out.

    Already inventory is backing up. At least 1/3 of the employement gains in this “booming” economy are real estate realated. Now look at WaMu and others are laying off employees. Look at the large home builders not paying their subcontractors. Can anyone say cash flow?

    I would not be surprised if we are not aleady in a recession. And it will always take the main stream opinion by surpirse.

    I’m sorry, I forget, business spending is going to pick up for the consumer. I am still waiting to see the business expanding capacity as the consumer pulls back. Hell, there is demand for gasoline and the oil industry won’t expand capacity in refineries. Business investmetn is a joke. IBM is investing $6 Billion in India and I would say they haven[‘t invested $6 Billion in the US in the last 5 years.

    I agree. with Barry, ignore at your own risk. Then everyone will bee saying they can[‘t believe how quickly things turned.

  14. VL says:

    RB-

    Thank you for providing the links, the model is interesting, but it is far from perfect. According to this model the probability of a recession within the next 12 months is 1 out of 3 – this is assuming the perfect environment and nothing dramatic in the near future (like the housing market collapse). Also, the model does not tell us anything about the probability of a recession within the next 14, 16, or 18 months.

  15. VL says:

    Estragon-

    “I think we’re in somewhat uncharted territory here.”

    According to Citibank their international consumer business reported a 6% increase in net income last year and their US consumer business saw a 10% drop. The domestic results were hurt by rising interest rates (net interest margin compression) and a spike in bankruptcy (according to Citibank).
    Basically, if you are investing in Citibank now for example, you are not investing but you are speculating that either Citibank will not experience continued margin compressions or the rate of bankruptcy will fall.
    I would avoid all bank stocks because:
    1. The inverted yield curve will hurt their net interest margins.
    2. Slowing of the economy and the housing market collapse will keep the rate of bankruptcies high.
    (There is so much wealth in the upper 5%-10% in this country, the rich compound their returns from the bubbles in stocks and housing while the middle class has too much debt.)

  16. VL says:

    Bruce Sherman-

    “Yet the big banks (e.g., BAC, C) have outperformed the market recently”

    It was likely the result of short term drunken euphoria about the possibility of the Fed pausing and the market is going to take off again. The price spike on Thursday was likely the result of short-covering and traders following the herd for a trade. (Many shorts were betting on 25-50 bp with hawkish statement from the Fed resulting in market sell off, but 25 bp with dovish statement produced panic and short-covering).

  17. whipsaw says:

    I think maybe you guys are missing something with the BAC/C discussion- altho it’s true that interbank rates matter, banks don’t stay in business by borrowing money via the fed reserve system. They borrow money from customers via demand and time deposits for which they pay sub-market rates or sometimes nothing which is then loaned to customers at somewhere between prime + n and the usurious rates on credit cards.

    As short rates increase, there is obviously an impact on lending cost structure, but that is passed along as prime increases too. Fixed rate loans can be sold off or hedged while there isn’t a big problem with existing credit lines that float unless and until defaults pick up. That comes eventually during a recession, but Big Bankers are pretty good at seeing over the horizon (partly because they are big enough to play a role in creating what is seen) and rarely get blindsided.

    Big Bank loan portfolios are not built around consumer lending anyway and the regional and community banks are the first to take the hit once layoffs start and the little guys get squeezed. At the other end of the spectrum, Big Employers are cutting costs by cutting people, so they minimize the impact of a slowdown on their net revenues and can still pay the Big Banks even if it diminishes net profits- so no default on that end and the possibility of needing to borrow more money.

    So my basic explanation for why (big) bank stocks would be relatively attractive is that the Rich Get Richer. But they are still going to go down with everything else, just to a lesser degree, so if you are a long-only fund manager who has to be in the market to some extent no matter what, then bank stocks make as much sense as anything.

  18. HT says:

    When the yield curve inverted first several months ago, the media couldn’t get enough–now it’s hardly mentioned in passing. Interesting.

    Second, I [like everyone else] have been trying to determine if Bernanke is a dove or a hawk. He seems to be overly influenced by polls, media, and market gyrations– a bad thing and sure to add to volatility. The last statement, however seems clear [for now, of course], that he’s a dove. Gold, commodities , emerging markets, and small caps had much larger rallys than the Dow etc. My bet is the gold trade is back on, as the smart money bet is inflation is more likely to get away from the fed. Plus, its the conventional wisdom the fed overtightens–maybe the contrarian play is in play.

  19. whipsaw says:

    per HT:

    “The last statement, however seems clear [for now, of course], that he’s a dove. Gold, commodities , emerging markets, and small caps had much larger rallys than the Dow etc. My bet is the gold trade is back on, as the smart money bet is inflation is more likely to get away from the fed.”

    I read the 8 sentences of the statement as promising more of the same, however you may choose to characterize that. But I would agree that most markets saw things your way.

    The problem is that markets are becoming more media driven than event driven, i.e., a halt in interest rate increases means that the economy is screwed, but you won’t find any talking heads who acknowledge that. Well, maybe Barry would, but otherwise…

    Here’s my Whipsaw Deadbang Cinch Indicator:

    As long as the financial media obsesses with what the FOMC does, we are either about to head into the tank or already heading into the tank. Once that becomes a yawn event, all is well. The latter will occur sometime between 2010 and 2012.

  20. RB says:

    VL,
    You’re right, but the point I was trying to make was that the popularly used 2yr/10yr spread has given false alarms while every recession has always been preceded by an inversion at the 3-month/10yr spread… which we don’t have yet.

  21. RB says:

    VL,
    Further, the market conditions are priced into the bond rates used for the probability calculation and so the model is self-contained. Besides, since models are usually not complete, absolute numbers of probability are not as useful as the comparisons with calculations at times of previous recessions. In that context, the 1 in 3 chance should be compared with the 50% probability reference for reasons explained in the earlier posts.

  22. JD says:

    “In the past, a marked flattening or an inversion of the yield curve generally signaled an impending recession,” said Frederick Furlong in a San Francisco Fed Letter, “The Yield Curve and Recessions.” “In the current economic environment, we cannot be sure that a flattening or an inverted yield curve has the same meaning as in the past.”

    Furlong wrote that in March 1989, shortly after the yield curve inverted and four months before the economy slipped into recession.

    “Although models based on the slope of the yield curve do fairly well relative to other macro and financial variables, their absolute forecasting ability is not great,” wrote Christopher J. Neely in the St. Louis Fed’s Monetary Trends. “Developments in the structure of the economy might change the relationship between the yield curve and economic activity.”

    Neely wrote that in August 2000, three months after the curve inverted and eight months before the start of a recession.

    AND FINALLY….

    Yields on 10-year Treasury notes ended 2005 below those of
    two-year notes for the first time since December 2000. Such an
    inversion in the yield curve has preceded the past four
    recessions. “That’s a horse with a track record we would rather
    not go against,” David Rosenberg, chief North American
    economist at Merrill Lynch & Co. in New York, told clients this
    week.
    The Bush administration sees it differently. “There is no
    requirement that when we see an inversion that that is
    predicting a recession,” Snow said yesterday during a call-in
    show on C-SPAN, the cable-television public-affairs channel.
    “The correlation has weakened over time, and is no longer very
    strong.”

  23. I dont know if that was really Ned Davis posting (I pinged him) but he has a good interview in Barrons this week

    I’ll get up an excerpt eventually

    http://online.barrons.com/article/SB115170849821395833.html

  24. Craig H says:

    The inverted yield curve is just one indicator warning of at least a decrease in corporate earnings, or at worst a recession – and a drop in stock prices that would accompany either.

    I think we need to consider it along with other phenomenons such as a discount rate over 6%, falling home prices, the presidential election cycle, and the average length of a bull market run.

    I’m sure you guys have some others.

  25. HT says:

    per Whipsaw–

    we agree. my point was only for a trade, it’s the best bet. Eventually, Bernanke will have to control the freight train of inflation [if the housing market tanking doesn't first]. So, no, gold isnt a buy and hold.

  26. Leisa says:

    I thought that SFO had a good article in this month’s issue about the inverted yield curve. http://www.sfomag.com/articledetail.asp?ID=1946685477&MonthNameID=July&YearID=2006. Interestingly the 2yr/10yr inversion was touted as the most accurate.

  27. Periodista Miguel says:

    Minor point to make in an interesting discussin:

    >>>>“In the current economic environment, we cannot be sure that a flattening or an inverted yield curve has the same meaning as in the past.”

    Furlong wrote that in March 1989, shortly after the yield curve inverted and four months before the economy slipped into recession. <<<<<<

    Either the date is wrong or the description. Economy hit recession in the summer of 1990.

  28. Russ Winter says:

    Brazilification of America Now Complete:
    http://www.xanga.com/russwinter

  29. Speedlet says:

    RE: Whipsaw’s comment –

    The 3-month and 10-year did in fact invert for a short time at the end of last year, then normalized. Now they are beginning to re-invert — they are a measly 2 BP apart. Hardly something to pin your hopes on.

  30. speedlet says:

    Amendment to the previous comment –

    As of today, July 17th, the 3-month is yielding 5.10% and the 10-year 5.06% (according to Bloomberg.com).

    So now the 3-month and 10-year are inverted as well.