On Inverted Yield Curves and Recessions - Yay!

OK, this will be one more economics-related post, and then we can shift back to discussing more important topics, like old movies I've watched lately. Hey, they don't call economics the dismal science for nothing!

I've been thinking lately that all is right in the world of economics, or at the very least, I think that's a true statement. It would be interesting to get a reading from an actual economist on this. See, there is a very accurate predictor for the U.S. economy entering a recession: the inverted yield curve. According to whoever* wrote the entry on Wikipedia, an inverted yield curve accurately predicted worsening economic situations two to six quarters into the future five out of six times since 1970.

* Whoever or whomever? Whomever probably sounds right to more ears, but since the preposition in question does not indicate a person to whom or on whom an action was performed, I think whoever is correct. We're talking about the person who wrote the page, or the person who performed the action. Whoever.

A normal yield curve, in which the long-term rates are higher (and usually significantly more so) than short-term rates, appears below:



You can see that long-term yields (on the 30-year and 10-year Treasuries, for example) are significantly higher than those for the short-term Treasuries.



An inverted yield curve is exactly what it sounds like. Short-term bond rates spike to higher levels than long-term rates; Wikipedia indicates this is partly due to expectations that inflation will be low during a time of recession in the economy. The graphic below shows what happened mostly in 2006 and 2007 between the 2-year Treasury and 10-year Treasury rates:



You can see that the 2-year notes had significantly higher yields than did the 10-year notes, in some cases approaching 200% of the yield on the longer-term bonds.

Why is an inverted yield curve so bad, you ask? In normal situations, people require a higher expected payout (in the case of bonds, a higher interest rate) for tying up their money for longer periods of time. Keep in mind that with bonds, price and yield always move inversely to each other: when prices on bonds go up, the yield automatically goes down, and vice versa. What drives the price of a bond up? The same as anything else: demand. In the case of an inverted yield curve, no one wants to purchase the short-term bonds, driving the price down and the yield up.

A lot of what happens in the relationship between long-term and short-term yields also has to do with investors' expectations, as mentioned before, and with what types of Treasuries are being offered for sale (usually at Treasury auctions). Between 2001 and 2006, the Treasury Department didn't auction 30-year notes at all. The longest term bond a person could buy from the Federal government was just 10 years, and that was partly what led to the inverted yield curve.

Another factor that led to the inverted yield curve was the Federal Reserve aggressively raising interest rates* in 2004-06 when worries of inflation gripped the new Fed Reserve Chairman, Ben Bernanke. I have to laugh at this article from February 2006, when Bernanke said "the inverted yield curve would not bring recession this time." Think he would like a mulligan on that one? How quickly did they reverse course and lower rates, trying to avoid the pending recession? (WSJ article, registration may be required) Here's a graphic from that article showing the target overnight rates since 2000:


* I really shouldn't fall into this same trap that all the news media does when discussing the Federal overnight lending rate, or target Fed rate. The Federal Reserve does not directly set what interest rate Federal Reserve banks use to lend to each other. Rather, the Fed does change how much cash a Federal Reserve bank needs to keep on hand at any one time, which then has an influence on what interest rate they use when lending to other banks. That's why it's called a target interest rate, not a definitively set or effective interest rate.

One reason why economists pay attention to the yield curve and any oddities thereof is because recessions typically cannot be forecast with any certainty. The official definition of a recession is a minimum of two consecutive quarters of negative GDP growth. Because everything is backwards-looking, by definition, the economy has to already be in a recession for at least six months before you know it. An inversion of the yield curve is one of a very few economic indicators that can predict trends in the future, rather than waiting and looking back at the data.

So, back to my original point, where I said that everything was right in the world of economics these days. At first, it appeared that the inverted yield curve of 2006 was not going to forecast a recession in the U.S. economy. 2007 was still a fairly happy year for consumers and investors alike. The crap didn't really hit the fan until 2008, when Wall Street melted down after home values fell off the cliff and banks had to start writing off their bad loans. Was that still within the typical two- to six-quarter window mentioned above? I think the recession probably hit within that window, despite the yield curve returning to normal, so all must be right in the world.

Sad to say.