Many people look for an inverted yield curve to signal a recession. The track record is good. The yields on longer term maturities decline in relation to shorter term yields. Let me show a version of the inverted yield chart that I haven’t seen anyone do yet.
I take the 3-year Treasury constant maturity rate and divide it by the 10-year Treasury constant maturity rate. Then I take the 1-year Treasury constant maturity rate and dived it by the 10-year Treasury constant maturity rate. (quarterly data)
When both of these lines go above 1.0, the yield curve is inverting and a recession is coming into view. It has been a fairly reliable chart to signal a recession.
The lines are very low at the moment because the Fed rate is near the zero lower bound. It is unlikely that shorter term rates will rise much. The Fed is in a labyrinth and cannot find the exit from the zero lower bound. They are concerned about financial stability… and just tapering of QE creates an apparently “unacceptable” level of instability.
In a normal world, the two lines in the above chart would have already started upward. We no longer have a normal world.
The question is whether a recession can start without having an inverted yield curve. Even Wikipedia connects the two in absolute terms…
“Since the financial crisis of 2007–2008, the U. S. Federal Reserve has maintained a zero interest-rate policy (ZIRP) for an “extended period of time”, where the short term interest rate is practically set to zero. Therefore a recession is unlikely to occur until this policy is reversed.“
Interesting statement. Wouldn’t it be nice if we could just maintain a zero interest rate policy and never have a recession?
In order for the yield curve to invert this time around, longer term rates would have to come down to almost zero. Normally the shorter term rate would rise before a recession, but policy will keep shorter term rates near zero as far as the eye can see. The 10-year rate did go down below 2% in 2012. Can it go further down? Actually it could… But all the way to a zero lower bound? It’s wild to think about that possibility.
It seems reasonable to assume that the yield curve will make an attempt to invert before the next recession, but a complete inversion would require the Fed to raise its overnight interest rate. The Fed is forecasting a rise in the Fed rate in 2016. So maybe the implication is a recession as far out as 2017 or 2018.