Yield Curve As a Signal for Reccesion

 25 March 2019
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Yield curve is one of the commonly watched indicator by investors.  In the past,  it has been used as a  signal for the start of a recession.  It was found to be quite accurate over many many years before 1980.   Many talked about the inverted yield curve in 2008 to predict the  last great recession in 2008/09 but recession only came after the SubPrime crisis exploded many months after.

Today,  it is the talk of the town again.  Many articles called out for the attention of the investors.

What Do the Yield Curves Tell us?

Here are some yield curves of the various countries

The above yield curves show that the US yield curve’s short term rates have inverted over the last 6 months.  The same was observed in the yield curves of the other countries except for China which showed an even better yield curve than before.

According to the conventional wisdom,  one would judge that China’s yield curve is the best and Hong Kong’s yield curve is the worse.  In between is Japan and  US States.  

How Accurate and True is the  Conventional Wisdom?

It is accurate and true if the  Market players have been given the right to determine and set the price of the bonds in a free market.  However,  the yield curve may mean nothing if the bond market is heavily manipulated.  Take US for example,   Fed sets the rates of the short term bonds, leaving the market players to determine the long term bonds.  Fed also interfered the market by buying Treasury Bonds and Mortgage Back Securities from the Banks,  seriously interfering the bond market,  making  the market a totally different “animal” altogether when compared to those markets in the 1960s. 

How and Why?

Fed was founded in 1913 to control financial crisis and prevent bank runs. It has the mandates to maintain market stability and to maximize  employment.  It tweaks  monetary policies and adjust  Federal fund rate to control and tame the inflation.
 
Fed was able to control Federal  fund rate to within 5% over the years.  It was about 6%  during the Great Recession in 1929. The control was maintained at below this rate until end of 1960s.  From then on,  the rate went all the way up to 20% as recorded in  Dec 12 1980.  The rate then returned gradually to the present level of 2.5 to 3%  as shown in the following chart

The bond market,  especially the short term bond market,  have been manipulated heavily by Fed.  However,  all these years,  Fed was able to leave the long term bond market like the 30 years untouched until after 2008 when Fed started the QEs and purchased large amount of Treasury Bonds and Mortgage Backed Securities from the Banks. This action of Fed affected also the market for the  long term rates. 

The following chart shows the differences before and after  1980.  After 1980,  Fed kept rate hike averaged below  7%. 

One could observe

1)  Before 1980,  recession often happened just after a rate hike.  The rate hike has also inverted the yield curve as evidenced by the 1-year shooting above the 10-year bond rate. This,  however, did not happen after 1980.

2)  The 1-year bond rate has been manipulated and pushed way below the 10-year bond rate especially after 2010.   The 1-year bond rate did not even have the chance to fully form an inverted yield curve before the recession began;  also

3)  The yield curve improved over and during all the recessions after 1980.

What Do All These Mean?

It all mean that we are now looking at a different “animal”;   in other words,  an inverted yield curve might not necessary signal a recession has started although it is highly probable that a recession is in the making or about to happen.   It is also probable that a recession could be reverted as the recessions  are more crisis  related and would recede once the crisis is removed.  As  a result,  one might expect the inverted yield curve to "stand" for a much a longer period and recession might not have even started. 

Presently,   the Fed rate and bond yields are extremely low.  Even the Pension Funds do not find bond investment attractive.  Many Pension Funds was reported to put more than half of their assets in the stocks.    This has made today's yield curves to look very much different than those days when bond  was a natural choice  of investment for the Pension Funds.

It would appear that one should not just depend on  inverted yield curves to predict the present of  a recession. Also,   the present Fed fund rate is so very low that cutting Fed rate will not significantly help solve crisis related recession  such as a Trade War. 

In Conclusion

The presence of a inverted yield curve has been taken to be a reliable to predict a recession before 1960.  This is no longer the case after 1980.  However,  one can still use it to express a  recession is in the making.   

Presently,  the Trade War between US and China and other events like Brexit have  significantly affected the Global economy.  These are something that monetary policy controls cannot help until they are resolved and ended.  Therefore,  it would be better for investors to monitor the progress of these significant events rather than monitoring the development in the yield curves.

Should one still wanted to monitor the progress of a recession in the absence of any crisis,  a better tool to use is to monitor the rise of the yield spread as described in this article.