Reader Eric is curious about yield curve inversions. He writes …
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
Mish,
Re: Reader Questions on Yield Curve…
Is there an answer to your question: “At what point does this all collapse anyway?” or is the answer embedded somewhere in your discussion and I’m just too dense to see it?
Dennis Smith
We are all searching for the answer to that – and also where (what country) it starts
Mish
It seems to me that the predictive value of yield inversions is “lost” when the market is dominated by Central Bank purchases. Looking at old charts is a waste of time.
I agree. Was not one of the Federal Reserve “Operation Twist” specifically aimed at lowering short term rates? And thus screwing this indicator so everyone bops alone not knowing we’re in a recession. ( Unless you’re looking for a job! )
The economy has been sucky since the crash. I don’t think we ever really recovered.
Operation Twist targeted the long end of yield curve.
@ not knowing we’re in a recession. ( Unless you’re looking for a job! )
when your neighbor is looking for a job it’s a recession.
when you’re looking for a job it’s a depression.
“At what point does this all collapse anyway?”
I have been expecting it for quite a while now (since Oct 2014 – Bullard low) but every time it looks like this is it, the Fed (or its mouthpieces like Bullard) or the other central bankers have been able to not only pull it back from the edge but also keep propelling it. Makes you look like a permabear or a fool, with people constantly comparing you to a broken clock. Unfortunately given the central bankers intervention on a constant basis (indicating things are not rosy, if not dire) does not induce confidence. Probably the only way is to “Think like a bear, Act like a bull” (Lance Roberts latest!) till the whole thing collapses. How long these guys can keep the balls in the air is anybody’s guess.
“Think like a bear, Act like a bull” (Lance Roberts latest!) till the whole thing collapses.”
Retail will get crushed … as always.
There is no bell at the top. Market will seesaw down and investors will stay in for the duration paralyzed by thoughts of missing the bottom (CNBC will be screaming “bottoms in” at every upturn) and paying capital gains.
Centrally planned economies tend to act differently than free market economies. Data mine the 20th century with caution. Centrally planned economies tend to be inefficient, and spiral toward banana republic status. Expecting 20th century return on the balanced index may be unrealistic. Even if valuations were normal (which they are not), the spiral toward a banana republic would affect return. The majority cannot outperform the index. Most investors who try market timing find it to be counter productive.
Printing is the bank’s war on investors (hapless 401k/IRA savers).
You could compare it to yield curves from the Soviet Union or other communist countries, who ironically sported fractional reserve banking systems much like those in the West.
The USSR is certainly an example of how inefficient central planning is, but they did not have a stock market similar to ours. No way to calculate the return of a balanced index over there. The banking system was mostly for foreign transactions, and did not have the same effect on their domestic economy as in the US.
There are many third world examples of printing their way to a banana republic.
The USSR survived as long as it did because , central planning aside, they actually had a significant market economy. Not a stock market, but a market economy as in: after serving the state for five years, a professional could hang out his shingle; and nonprofessionals could garden, process farm foods, and sell their produce in markts.
If you wanted to argue, I would more likely take the position that the US does not have a market economy; but in fact the US does, though it is quite damaged by wall street and the FED.
I think the more accurate explanation would be that 2 and 3 yr are very thinly traded compared to the rest of the curve. Public and commercial does not come after 2-3 yr paper. Therefore traders sell 1 yr and 5-10 yr and are the only buyers of 2 and 3 yr in order to hedge their shorts. Essentially left with – + + – position in term. A good spread at the right levels, but you can only do it so much when you already are choking on it.
Looking at the 2 and 3 for an inversion just raises my eyebrow.
I would answer Yes, to your reader Eric. The 1-10 or 2-10 inverting would be an inversion.
I do agree with you though that there is no reason to believe that is recessionary.
Nothing is going to change until after the elections anyway. The fed and banks have basically been given a freehand to keep this baby afloat. We cannot have any problems leading u to the elections otherwise Hillary will take a big hit. Now if Trump wins the election watch this baby crater. After all they can blame Trump being elected instead of taking responsibility for their actions.
During election years you can indeed make some good money investing. This and the last election cycle have been really strange for private investors. This cycle returned to normal for me anyway.
Just my humble opinion and it does not matter what party is sitting in the oval office. Betting against the Fed right now will cost you. All bets are off after the election in my small mind charts or not.
Watch IRS tax receipts growth rate. Very reliable recession indicator. Impossible to game. Says we are in recession right now. This sucker is going down now.
withheld and employment tax collections flat lining year over year for past 3 months.
Right. So slope is zero. Only happens in recessions. Reaches zero in middle of recession. We’ve been in recession about a year.
Mish,
Would the zero barrier become a non factor if you used net yields after inflation to look for an inversion?
James
Fed mandate should be changed from preventing recessions (which only serve to cull out mal investment) and be charged with enhancing the price discovery mechanism of the markets (which they have destroyed).
Changing the Fed mandate will not achieve much as long they themselves set S&P as their mandate. Incidentally I feel there should be only one mandate-maintaining purchasing power…
“Did the Fed’s QE bond buying prevent a deep 2013 recession in the US?.”
Well, that is certainly what the FR wants people to think.
I don’t buy that … any of it.
What prevented a downturn were the tax INCREASES that went into effect January 1st, 2013. A lot of income (best guess $250 billion to $400 billion) pulled forward (in some cases YEARS via special dividends and capital gains) into 2012 to avoid hike. No doubt much reinvested, but even a small percentage spent provided enough economic boost to keep economy out of the ditch.
I don’t think it is easy to identify a recession anymore. Many will argue that we never really left the last recession.
Record number of people on food stamps.
Low Labor force participation rate.
Higher paying tech jobs going to h1b Visa holders from India.
Manufacturing jobs to China.
More small businesses closing than opening.
Fewer retirees with a sense of financial security etc.
I think we are turning Japanese, really. Look at them from 1990 and just pasye it all on our future.
Int’l money flows have created the rise in stocks, which is not acting like a bubble yet. If the Fed raises, it will trigger the intl default contagion, which will accelerate the flows into stocks, and pop the govt debt bubble, which will produce your stock bubble, that has little to do with fundies in a world where stocks become the safe haven.
That’s the first time I have heard a bubble called a safe haven. Good luck with that.
yeah, market has risen on low volume and stock buybacks. Raising rates will put a dent in that activity.
Sovereign debt of reserve currency countries will still be standing after equities fall.
“But I don’t want to go among mad people,” Alice remarked.
“Oh, you can’t help that,” said the Cat: “we’re all mad here. I’m mad. You’re mad.”
“How do you know I’m mad?” said Alice.
“You must be,” said the Cat, “or you wouldn’t have come here.”
I think all the feds around the world have been using low rates, ZIRP, and NIRP to keep the curve from inverting. When the raise interest rates, if I percieve this correctly, they have to pull money back in to match. 25 basis points triggers 600 billion dollars buy bach to successfully pull it off. August last year, they tested by just pulling thel currency back and triggered a crisis, so they didnt hike and instead, put more currecy in to counter act. In December they hiked and caused market pullbacks for the month of Januar. Instead of pulling currency off the table, they added and markets rebounded. If is true and economy is already slowing down, it will crash on another hike or two. I have pictured the Fed as trapped and fully expect them to talk the game and cut rates in the future.
“Bernanke did not think we were in one in 2007 when it hit.”
Recession started December 2007.
At June 2008 FOMC meeting, they thought not only no recession but UPGRADED growth for H2 2008.
Clueless is being generous.
Bernanke could have known but played it up with rhetoric. The fed does ont opetate in our interest, so you would expect deception.
Instead of focusing on what pair, use them all. This is a quick monthly chart since ’81 showing the average of the difference of each yearly maturity http://i.imgur.com/Kx8wXUy.png. At current rate of flattening things would get interesting in 2018!
Instead of focusing on what pair, use them all. This monthly chart since ’81 shows the average of the difference of each yearly maturity http://i.imgur.com/Kx8wXUy.png. At current rate of flattening things would get interesting in 2018!
Dear Mish,
I want to copy your stunning announcement of the $6.5 T lost by the Army last year but cannot.
I want to send it to West Point classmates who naïvely waste their time complaining about QE & ZIRP to politicians whereas there may be a way to start confronting Mc Cain.
Also it appears that there are more T’s in prior years for the Army & other departments. What does the retired head of GAO have to say on that subject?
Thanks,
Bill >