Reader Questions on Yield Curve Inversions as a Recession Indicator

Reader Eric is curious about yield curve inversions. He writes …

by Mish

Hi Mish
I’ve been a loyal reader for many years. Regarding the yield curve inversion, which pair is the best, most reliable indicator of a recession? As you mentioned in your post there was an inversion between the 6 months and 1 year, but short term fluctuations can create temporary graphical anomalies. Is the bedrock of the inverted yield curve the 1-year to 10-year spread?
Thanks.
Eric

Eric is inquiring about my post Yield Curve Inversion Coming Up?

An inversion occurs when shorter term rates have a higher yield than longer dated rates. Typically this is a strong recession warning.

The 2-10 spread was always considered a classic spread to watch, and the St. Louis Fed has a predefined chart. But I expect the next recession to hit before the yield curve inverts.

Why? Because yields at the short end of the curve are simply too close to zero for the curve to invert.

Discard any notions that a yield curve must invert before a recession. Recessions without inversions happen frequently in Japan.

2-Year to 10-Year Spread

The 2-10 spread is +81 basis points. That gap will not close unless the Fed hikes at least twice.

Short duration differences such as 3-month to 6-month have been extremely noisy. Even the 1-month to 1-year is noisy.

Here are a couple of charts I created that do provide a reasonable basis for discussion.

Please note the vertical scales on each chart are dramatically different.

1-Year to 2-Year Spread

That looks pretty prone to some false signals.

2-Year to 3-Year Spread

The 2-3 and 2-10 charts are very similar in appearance. Neither had the 1995 head fake of the 1-2 spread.

I am keeping a close watch on the 2-3 spread. It could easily invert on even a single hike.

The 2-10 spread is +81 basis points while the 2-3 spread is a mere +12 basis points.

Canada Inversion and Recession

When Canada’s Central Bank unexpectedly cut rates on January 21, 2015 the Canadian yield curve immediately inverted out to three years as noted in may post Canada in Recession, US Will Follow in 2015.

Canada did indeed go into recession as noted on September 2, 2015 in Canada in Recession with Two Consecutive Quarters of Negative Growth.

Us Recession?

My call for a US recession has still not come to life. Given massive backward revisions to GDP it would not surprise me in the least if we are in one now.

This will cause some to make “stopped clock” comments.

However, economists have never predicted a recession in advance. Never! Most do not think we are in one after they arrive.

Bernanke did not think we were in one in 2007 when it hit. Nor did the ECRI.

The ECRI and I both thought there was a recession near the taper tantrum that never came about. But it’s possible a very mild recession did hit or was narrowly averted.

For discussion readers may wish to consider the AEIdeas article Did the Fed’s QE bond buying prevent a deep 2013 recession in the US?.

The Fed may have prevented a recession, but at the expense of creating a massive stock market bubble.

At what point does this all collapse anyway?

Mike “Mish” Shedlock

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