For decades, extended inversions of the yield curve — when yields on short-term Treasurys surpassed those of long-term ones — have been considered harbingers of recessions. Now, it might seem like a disappointment.
Odd to call the potential lack of a recession a disappointment, but anytime trusted methods and metrics seem to fail, it certainly isn't something celebratory. What if you stop trusting the signal and next time it proves right?
Watching the yield curve as a portent of future economic stability has historical cred. "Numerous studies document the ability of the slope of the yield curve (often measured as the difference between the yields on a long-term US Treasury bond and a short-term US Treasury bill) to predict future recessions," as the Federal Reserve Bank of Boston wrote in 2020. "Importantly, the predictive power of the yield curve seems to endure across many studies, even if the specific measure of the yield curve and other conditioning variables differ. Indeed, with each new episode of "yield curve inversion"—when long-term interest rates fall below short-term interest rates—recession probability models are dusted off and re-estimated."
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As the bank noted, there was a 2019 yield curve inversion from May into early October. However, the recession that followed was during the pandemic and an issue of supply chain disruption and increased panic buying of necessities as shelves emptied and stores closed.
Chris Neely, an economist and vice president at the Federal Reserve Bank of St. Louis, said in a podcase for the bank in September 2023, "There have been false positives. For example, there were high probabilities of recession when no recession occurred in the late 1960s and late 1990s."
And back to the Boston Fed, which explained that most inversions happen "because the central bank raises the short-term interest rate above the long-term rate in reaction to a rise in inflation and/or inflation expectations that often is associated with an overheated economy." However, Fed monetary policy during the 2019 inversion had been "unusually accommodative."
Compared to actions the central bank took during the pandemic, the Fed in 2019 might as well have been run by monetary hawks. Long-term rates sunk rather than lower-end numbers rising. Investors assumed that the future would be times of easy money, with longer-term Treasurys taking a yield beating.
The year 2024 may be another anomaly. "This time around, though, it is starting to look like the curve may normalize because longer-term bond yields would rise in a bear steepening, interviews with half a dozen investors and other market experts show," Reuters reported. "That is due to pressure on longer-term rates from increasing U.S. debt, while a surprisingly robust economy and sticky inflation keep the Fed from cutting rates."
Then again, it may be that the clock has been reset. The Financial Times quoted Steven Blitz, managing director of global macro and chief U.S. economist at GlobalData TS Lombard, who in February reemphasized his view that accounting for inflation, the real yield curve only recently inverted.
"This is, in many ways, a repeat of the policies that led to the 1969 recession and, in turn, the great inflation of the 1970s," he wrote — that is, stagflation. "Then, the real curve only turned negative after the nominal curve had been inverted for 13 months — against a backdrop of increased procyclical fiscal spending. The real curve is now inverting after 12 months of a nominal inversion, and I expect some further slowdown in credit extensions. Credit issues are now coming to the fore, notably CRE. This sector has, however, been more impaired by shifting work patterns than the level of interest rates, real or nominal."
It's apparently rare for an inflation-adjusted yield curve to invert after the nominal (no inflation adjustment) because the real one is typically the first to flip.
If so, it's potentially another stone in the wall of keeping interest rates high. Or, if luck turns bad, higher.
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