Why you shouldn't worry about the inverted yield curve

We shouldn’t exaggerate the probability of the recession because of the yield curve’s inversion, and here are seven reasons why.

On March 22, the yield curve again inverted, this time between 10-year Treasury securities and 3-month bonds. This has sparked worries among investors regarding the short-term outlook of the economy. I have already written on why yield curve inverts and explained macroeconomic forces behind this phenomena. In this article, I want to cite reasons why recent inversion, as opposed to conventional wisdom, doesn’t indicate a forthcoming recession.

1. Track record is small. We had a little over 50 years of data and only 7 recessions. This is not a huge sample from which to infer reliable conclusions. In order for a yield curve to be a truly precise indicator, there should be more corroborating evidence.

2. Imperfect predictor. Even though in most cases inverted yield curve preceded the recession, twice in the history the yield curve inverted but the recession didn’t occur — in the 1980s and 1990s (see the graph above)

3. Distortions due to global central banks’ policies. European Central banks and Bank of Japan are massively buying their countries’ long-term securities, and this drives investors into the US market, creating an overestimated demand for the US long-term securities which results in a lower yield for them. Moreover, the dollar’s value has been decreasing, and this is making US securities even more attractive to foreign investors.

4. Quantitative Easing. In the wake of the 2008 Global Financial Crisis, the US Federal Reserve launched a multi-trillion dollar program called Quantitative Easing aimed at lowering interest rates in order to stimulate the economy. From 2008 to 2014, the Fed bought $4.5 trillion dollars worth of long-term Treasuries and mortgage-backed securities. This pushed long-term Treasury prices up and yields down. The study by Federal Reserve claims that QE pushed down interest rates on 10year treasuries by as much as 1%.

5. US Government’s demand for short-term funding. The US Government’s budget deficit keeps on rising, and the Treasury keeps on issuing more short-term (mostly) debt in order to finance the government’s activity. This expands the supply of short-term bonds on the market, pushing their prices down and yields up (bond prices and their yields have an inverse relationship).

6. Sluggish recovery. Recessions occur after economic expansions. But recent recovery from 2008 GFC is not a true expansion. Larry Summer famously called it “secular stagnation”, and only recently has the growth accelerated. So the theory of business cycles doesn’t support the fact that recession should occur.

7. Self-fulfilling prophecy. There is a possibility that IYC is not the indicator of the recession. Maybe when it coincidentally inverted twice before turmoil people began to believe in its predictive power. Their belief spurred them to actions that trigger recessions. Ironically, the fact that so many people think the yield curve inversion means a recession is coming can itself cause a recession. For instance, when consumers anticipate a recession, they spend less and the economic activity slows down, eventually leading to the recession. This is called a self-fulfilling prophecy, “a prediction that directly or indirectly causes itself to become true”.

It is estimated by the Federal Reserve of Cleveland that the probability of the recession is around 30%. Aforementioned fats do not mean that there will be no recession, but nevertheless mitigate the possibility of its occurrence.

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