“This Time Is Different.” Yeah, right.

Some economists don’t think the yield-curve inversion indicates another recession; Here’s why I think they’re wrong.

Former Federal Reserve Chair Janet Yellen interviewed with The Wall Street Journal about whether the U.S. is headed for another recession, as may be indicated by the inverted yield curve – the difference between long- and short-term bond yields.

In that interview, Yellen uttered four words an economist might come to regret: “This time is different.”

Interviewer: “We have something now called an inverted yield curve.”

Yellen: “Historically, it has been a pretty good signal of recession – I think that’s why markets pay attention to it. However, I would really urge on this occasion it may be a less good signal … We have had quantitative easing … this time is different.”

Interviewer: “You use those words that economists often regret: this time is different.”

Yellen: “Yes, I did.”

The inverted yield curve is more than a ‘pretty good’ signal, and I don’t think this time is different – let me explain why.

My 1986 dissertation at The University of Chicago first uncovered the predictive power of the yield curve for the business cycle. That said, my model is very simple and includes a single variable (the yield curve), and it is a lot to ask for it to accurately forecast recessions. My dissertation included the four recessions through 1985 and had a four-for-four record. After the publication of my dissertation, there have been three more recessions, each again presaged by a yield curve inversion.

So, we have an indicator that has predicted seven of the last seven recessions – without a false signal in the past 50 years, that seems better than “pretty good.”

On June 30, 2019, the 10-year minus 3-month yield curve inverted and I issued a recession “code red.” On August 14, 2019, another important part of the yield curve, the 10-year minus 2-year flashed inversion, providing confirmatory information.

As the graph above shows, longer-term yields have been plunging. In my last post, I referred to this as a “flight to quality.” When there are perceived head winds, investors flock to the safest asset in the world, the U.S. 10-year Treasury bond. This flight to quality has driven down yields. We also see the same phenomena in other countries. Also, note that yields have decreased in some risky countries too – like Spain. This is a carry-over effect – notice the risk premium (difference between Spanish and U.S. yields) is relatively constant. 

“This time is different”

The four most feared words from central bankers or policy makers are: “This time is different.” Yes, every situation is different. Looking at past recessions, each has its own characteristics. The question is: Have there been structural changes that are large enough to render the yield curve model broken? I think not.

1.     Is there evidence based on the historical track record that suggests the model is broken? If the yield curve model had predicted only five of the last seven recessions – that is, missing two of the three most recent recessions – this would be a source of concern. That is not the case. So far, the model has worked. There is no guarantee it will continue to work. To assert that it may not work, however, you need to make the case that something has changed.

2.     Is quantitative easing the factor that makes things different? I doubt it. During the global financial crisis, the Fed dramatically increased its balance sheet by buying assets. These purchases stabilized or increased prices, and lead to lower yields. However, since 2017, the Fed has been reducing the size of its assets (i.e., selling these assets back to investors). Theoretically, steady selling should lead to lower prices – and higher yields – but this is not what we have seen.  Longer-term interest rates have plunged. I attribute drop in the longer-term rates to a flight to quality, which is a direct result of fears about future economic results rather than the Fed’s QE program.

Source: The Federal Reserve. Scale in $ millions. https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

3.     What about the role of the deficit? The Congressional Budget Office just issued a report on the future projected U.S. deficits. They expect the 2019 deficit to be $960 billion and to average $1.2 trillion in the years afterwards. The size of the deficits has increased since their last assessment.  Their projections do not factor in a recession. Importantly, increased government borrowing does not explain the yield curve inversion. If that borrowing is long term, an increased supply of Treasury bonds should drive prices down and yields up. We are seeing the opposite with long-term yields falling. 

Source: Congressional Budget Office, August 21, 2019.

“U.S. economy has enough strength”

Another part of the interview asked point-blank about a recession:

Interviewer: “Are we going into a recession?”

Yellen: “The answer is most likely no. I think the U.S. economy has enough strength to deal with that.”

It is true that the fundamentals of the U.S. economy are strong. Real GDP growth is near 3%. Corporate earnings are strong. A fundamental indicator, the rate of unemployment, is near a historic low.

Source: The Federal Reserve Bank, St. Louis. https://fred.stlouisfed.org/series/UNRATE

However, we need to be careful here. By definition, GDP growth must be higher before a recession than during a recession. Unemployment is a classic lagging indicator. It goes up after we are already in a recession.

Corporate earnings tell us about the past. What we need is a lens to the future. This is the advantage of indicators like the yield curve. Interest rates are about future cash flows – not about the past. They provide a way to summarize important information: expected future growth, expected future inflation, and expected future risk.

 Bottom line

I think it is dangerous to brush off the yield curve signal because “this time is different.” No one has cogently made the case that conditions are sufficiently different to render the signal false.

That said, a model is only a model – a simplification of reality. Of course, the signal could be a false signal. In our particular economic environment, however, I don’t see any reason to declare a false signal before we see what actually happens. Given the track record of this indicator, ignore it at your own risk.