Recession’s canary?
Might a recession be coming?
(I’ve already called the housing market top, but I might be wrong!)
As the old alchemists searched for the Philosopher’s Stone, economists search for the Perfect Leading Indicator, whose appearance infallibly indicates change.
There’s an art to knowing when
Never try to guess
Toast until it smokes, and then
Twenty seconds less
With its usual laconic graduate-student prose, the Economist neatly lays out the hypothesis that, for looming recessions, it is the inverted yield curve:
SHORTLY before
Each time the blue line dropped below red equilibrium, a recession ensued shortly thereafter.
This is unusual. The government borrows by selling a variety of IOUs, which promise to give the buyer his money back sooner (three-month bills, for example) or later (eg, ten-year Treasuries). Normally, the longer the maturity, the higher the yield a security must offer: the “yield curve” slopes upwards. Markets take this to be the natural state of affairs (though just why it should be so has taxed some of the best economists).
When things are upended, the yield curve is said to be “inverted”, a condition now exciting much chatter among analysts.
The Economist offers two reasons why an inverted yield curve might be an economy’s flashing yellow light.
1. Statistical. When the light’s gone on, recession has followed.
According to a statistical model estimated by Arturo Estrella (link in .pdf), an economist at the Federal Reserve Bank of New York, a spread of 0.4 points, averaged over a month, has historically signaled an 18% chance of recession within a year.
By the way, Estrella’s piece (linked above) is a great further-reading on yield curves, well worth study.
2. Economically logical. The Economist then offers a remarkably cogent thought experiment showing how an inverted yield curve can be inferential proof of an investor’s belief in future interest rates:
Long-term rates represent, in part, the market’s expectations for future short-term rates. To see why, consider an investor who wants to lend for ten years. He could sink his money into a ten-year bond for the duration of its life. Alternatively, he could buy a five-year bond today, rolling his money over into another in five years’ time.
Suppose the five-year rate is 5% now, but the investor expects it to rise to 10% in five years’ time. In that case, ten-year bonds must offer a yield of about 7.5% today to attract his money. On the other hand, if the investor expects five-year rates to fall to just 3% in five years’ time, he will accept a ten-year yield of only about 4% today. In this case, long rates will fall below short now, in anticipation of even lower short rates later.
An inverted yield curve, then, suggests that short-term rates are higher today than they will be in the future.
“You don’t want to know what this is going to do to my economic digestive system”
Like any good oracle hedging its bets, the Economist then offers a counter-theory:
Heads or heads, I’ll be right either way.
In contrast to previous inversions, the yield curve is flat not because short rates are unusually high, but because long rates are unusually low. Yields on ten-year Treasuries have hovered around 4-4.5%, even as the Fed has hoisted short-term rates 13 times. Alan Greenspan, the Fed’s chairman, himself does not fully understand why this is so.
And a further caution:
Despite all this talk, the yield curve is not yet inverted across its full length. The yield on two-year Treasuries may have risen above that on ten-year bonds, but the rate on three-month bills still falls short by about 0.4 percentage points. The spread between ten-year and three-month securities has been this narrow twice before (in 1998 and 1995) without a recession ensuing. Nonetheless, the ironing-out of the yield curve is not normally welcome news.
Dangerous yield curve ahead, two-wheeled economist in jeopardy
In recessionary terms, the fat lady may not be singing, but she’s warming up.
Or is she?
Any damn fool can predict the past.
– Larry Niven.
