The inverted yield curve and the recession

The “yield curve” refers to a graph showing the relationship between the length of maturity of bonds – eg one month, three months, one year, five years, twenty years, etc. – traced on the X axis, and the yield (or interest rate) plotted on the y axis.1

In the postwar period, a “normal” yield curve sloped upward, meaning that investors generally receive a higher rate of return if they are willing to their funds in longer-term bonds.

A so-called inverted yield curve occurs when this typical relationship inverts, and short-dated bonds have a higher rate of return than long-term bonds.

Investors and financial analysts are very interested in this phenomenon, because an inverted yield curve (defined in a particular way) has been a perfect leading indicator of a recession going back at least fifty years.

If we look at the past eight recessions, starting with the slowdown that began in December 1969, a well-defined yield curve inversion preceded them all about a year in advance.

Moreover, during this same fifty-one year period, the (correctly defined) yield curve has only reversed when there would soon be a recession. (See endnotes for citations from the scientific literature. 2) The following graph illustrates the apparent predictive power of the yield curve:

Ten-year Treasury maturity rate minus three months

In the graph above (which only dates back to the early 1980s and therefore does not cover the full extent of the success of the yield curve), we have plotted the difference (or “”) between the rate d implied interest in ten. Year-Old Treasury Bills and Three-Month Treasury Bills The normal situation is that the yield on the longer ten-year security is greater than the yield on the very short three-month security. (This is why the graph line is usually above the black horizontal line at the 0% notch.)

However, every once in a while the yield curve reverses, meaning that the line on the graph drops below the 0% threshold, which is a situation where the yield on three-month Treasuries is in fact higher than the return in ten. treasury bills of the year. Notice in our table that whenever this happens, and only when this happens, the economy soon enters a recession (indicated by gray bars).

Economists have attempted to explain the mechanism by which an inverted yield curve signals an impending recession. As we will see, conventional attempts – like the one proposed by Paul Krugman – do not correspond to the real facts. In contrast, the Miseian explanation of the business cycle explains quite easily the trend we see in interest rates during the “normal” boom period and shortly before the fall.

Paul Krugman on the inverted yield curve

In his New York Times and associated blogging , Paul Krugman has clearly identified over the years investor expectations as the driving force behind the historic model. Here is Krugman at the end of 2008:

The reason for the historical relationship between the slope of the yield curve and the performance of the economy is that the long-term rate is, in fact, a prediction of future short-term rates. If investors expect the economy to contract, they also expect the Fed to cut rates, which tends to tip the yield curve negatively. If they expect the economy to grow, they expect the Fed to raise rates, which will cause the yield curve to slope positively. (added fat) 3

Then, in his column from mid-August 2019 – commenting on the then recent reversal of two-year and ten-year yields, which scared off investors – Krugman applied his framework to the data:

An old from economists says the stock market has predicted nine of the last five recessions. Well, an “inverted yield curve” – when interest rates on short-term bonds are higher than on long-term bonds – has predicted six of the last six recessions. And a fall in long-term rates, now less than half of what they were last fall, has again inverted the yield curve, with the short-long gap down to roughly where it was in early 2007, on the eve of a dire financial and the worst recession since the 1930s.

Neither I nor anyone else foresees a repeat of the 2008 . It is not even known if we are heading into a recession. But the bond market tells us that smart money has turned very bleak when it comes to the outlook for the economy. Why? The Federal Reserve essentially controls short-term rates, but not long-term rates; long-term low yields mean investors are expecting a weak economy, which will force the Fed to repeatedly cut rates. (added fat) 4

As the quotes above make clear, Krugman argues that the yield curve flattens / inverts before a recession because investors predict problems ahead. There are two problems with this approach.

First, why would an inverted yield curve scare investors if reason the reverse is that investors already know that a recession is coming? Second and more significant: Krugman’s explanation would make sense if yield curve reversals typically occur when long bond yields collapse. But in fact, as the following chart clearly shows, the yield curve reverses mainly because the short rate soars before a recession:

Ten-year vs three-month Treasury maturity rate

In the chart above, especially for the three median recessions, it is clear that the yield curve has inverted as the three-month yield (black line) rose rapidly to exceed the ten-year yield (green line). ). It’s the opposite of what Krugman readers would have expected to see.

Austrian explanation

Unlike Krugman’s story, the standard Austrian business cycle theory – which we explained in Chapter 9 – is quite consistent with the evidence presented in the figure above. Under Misesian, the unsustainable boom is associated with “easy money” and artificially low interest rates. When banks (run by the central bank in modern times) change course and tighten, interest rates rise and trigger the inevitable collapse. 5 (It is common in macroeconomics to assume that stocks of the central bank affect short-term interest rates much more. In fact, as Ryan Griggs and the present author have demonstrated, the evolution of the growth rates of the Austrian monetary aggregate from the “real money supply” ( TMS) corresponds quite well to the deviation of the yield curve:

Treasury yield spread vs money supply

In the graph above, the green line (corresponding to the left axis) represents the difference between the yield on ten-year treasury bills and the yield on three-month treasury bills. The black line (corresponding to the right axis) represents the twelve-month percentage growth of real money supply as defined by Rothbard and Salerno (and which we briefly discussed in Chapter 5).

As the chart indicates, these two series have a remarkably close connection. More precisely, when the money supply grows at a high rate, we are in a period of “boom” and the yield curve is “normal”, which means that the yield on long bonds is much higher than that on short bonds. . But when the banking system contracts and money supply growth slows, the yield curve flattens or even reverses. It’s no surprise that when banks “hit the brakes” with the creation of money, the economy soon goes into recession.

In summary, the standard Austrian explanation of the business cycle has, as a natural corollary, a simple explanation of the apparent predictive power of an inverted yield curve.

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