The Politics of Yield Curve Inversions

I never thought my scientific research could be politicized – but it has happened. Some have assumed my motivation in issuing a recession code red (as a result of the inverted yield curve) is a move to discredit the current administration. My model has existed since 1986 and it has been predicting recessions ever since. Nevertheless, it is useful to talk about the politics of yield curve inversions. Also, full disclosure, I am a Canadian economist living and working in the United States. As such, I cannot vote in US elections.

Is there a political aspect to yield curve inversions? Are they more likely under Republicans than Democrats?

Harvey: There have been only eight inversions since 1968 and thus not much data to draw clear conclusions. The table above shows the president who oversaw the beginning of the respective inversion. Some of the inversions spill over into more than one president. For example, the October 1968–February 1970 inversion began under Johnson, but he was out of office by January 1969 (indeed, on March 31, 1968, he announced he was not running for re-election). The spillover also happens for the second inversion under Carter. Overall, I do not see any pattern here. Of the eight inversions, four begin under a Democratic president and four under a Republican president. 

Do the politics of yield curve inversions come from the Federal Reserve chairs rather than the presidents?

Harvey: The answer to this question is complicated for multiple reasons. First, it is somewhat analogous to the question of whether the stock market does better under Democrats or Republicans. There are so many ways to investigate this (looking at President, President + House, President + Senate, President + House + Senate) that we run into a data-mining problem; that is, one party might look good by luck. The problem is worse for the yield curve, given there are only eight inversions in the sample period. Second, the role of the Federal Reserve has changed. Considerable recent discussion has focused on the “independence” of the Federal Reserve as a result of the President’s critique of Fed policy. This independence is a relatively recent phenomenon. Few would characterize Arthur Burns’ Federal Reserve as independent of the Executive Branch.

Nevertheless, for each of the eight inversions since 1968 I list the Federal Reserve chair when the inversion happened and the president who appointed the chair. Again, no clear pattern is apparent. Three chairs were appointed by Democrats and five chairs were appointed by Republicans. While a bit of a tilt towards Republicans, note that over the entire sample, 1968–2019, Republicans have held the Executive Branch in 31 of 52 years (I am counting 2019 as a full year). Nevertheless, the last four inversions have occurred under the watch of Republican-appointed Fed chairs. Statistically speaking, there is no “significant” pattern. [An aside: It will be interesting how the media handles the last two sentences; not including the second sentence substantially changes the spin.]

Third, and consistent with my first point on elections and the stock market, there are so many ways to cut the data. For example, the president nominates the Fed chair, but the Senate confirms the chair. A Democrat-controlled Senate confirmed the Fed chairs who oversaw six of the eight inversions. Note that Burns and Greenspan were nominated by Republican presidents and were approved by a Democratic majority in the Senate. 

Will the Fed try to uninvert the yield curve before the election?

Harvey: I can only offer an opinion here. I think “yes,” and the Fed will have some help from the Treasury. This is the most dangerous yield curve inversion in history. Let me explain why. In the past, yield curve inversions were not really talked about. Few had heard of my model. While my model successfully predicted the 1990–1991 and 2001 recessions, these recessions were mild and no one really noticed the yield curve. In July 2006, the yield curve inverted and, again, few paid attention. However, after the global financial crisis, many realized there was an opportunity lost because the yield curve forecast was essentially ignored. Now the yield curve is talked about in the mainstream media. I have been called “The OG Yield Curve Whisperer” by Planet Money and recently the “Godfather of Yield Curve Inversions” by Fortune. This media attention raises the real possibility of a self-fulfilling prophesy: both consumers and corporate executives can see a recession code red and reduce their spending, potentially leading to a slowdown.

The Fed likely wants a soft landing and one way to engineer it is to change the slope of the yield curve. Please note the circularity—which I am well aware of. The original model is not causal. The yield curve efficiently captures expectations of economic growth. Think of it as a wisdom-of-the-crowd indicator, however, the “crowd” is not the usual crowd. The investors in the bond market are very sophisticated in contrast to the stock market where many are retail investors. The yield curve indicator is flashing red. The Fed would like to change the color and will likely try Operation Twist III (but are unlikely to call it that).

The most likely mechanism the Fed will deploy is a subject covered in my last post. Whereas the Fed has been unwinding its balance sheet, it is still a substantial buyer of 10- and 30-year Treasury bonds. This buying drives up prices and lowers yields. My guess is that these purchases will stop.

The Fed will have some help from the Department of the Treasury. I expect that the Treasury will attempt to shift the maturity structure of the national debt more to the long end of the curve for three reasons. First, rates are very low, and it is best to lock in low rates for the long-term. Second, more long-term debt offerings will drive Treasury prices down and yields up. This includes offering new 50-year bonds or even longer maturity bonds. Third, the Congressional Budget Office expects the size of the deficit to increase which means more offerings which exerts upward pressure on rates.

It is extremely difficult to control the long end of the yield curve given the size of the bond market, but I expect both the Fed and the Treasury to attempt to normalize the yield curve. Will we dodge a recession? It is hard to say. Remember, my model is a model that forecasts growth, not recessions— although obviously the two are correlated. I do not believe we will dodge lower growth.