A Message from the Yield Curve

Submitted by Rich Toscano on December 27, 2005 - 8:22pm

The yield curve briefly inverted today: for a moment, the yield on longer-dated bonds was actually lower than the yield on shorter-dated bonds. To be specific, the yield on the 10-year Treasury briefly dropped below that of the 2-year Treasury, before rising up to close barely above the 2-year yield.

This brief foray into yield curve inversion is getting a lot of press, and for good reason. According to economist Paul Kasriel, a yield curve inversion between the 10-year and 3-month Treasuries has preceeded every recession over the past 45 years. Over this period, there were only two periods of yield inversion that did not precede a recession, versus six that did. That's a pretty decent economic indicator, though as Kasriel notes, it's a better predictor of economic activity in general than recessions in specific.

My take—admittedly simplified—on why yield curve inversions predict recessions rests on the manner in which financial institutions make money. Which is to say, they make money by borrowing at lower short-term rates (e.g. what you get from a savings account, which is essentially a loan to the bank) and lending that money out at higher long-term rates (e.g. the rate you pay for a home or car loan). The bigger the spread between short- and long-term rates, the more money they make.

Meanwhile, if the Federal Reserve raises the Fed funds rate high enough, they can push short-term yields higher than long-term yields (the former being more dependent upon the Fed funds rate than the latter). In this situation, it becomes very difficult for banks to make money in the manner described above. A yield curve inversion effectively chokes off the supply of credit, which in turn can cause a slowdown in economic activity.

Many analysts—and Greenspan himself—are saying that this time is different. (Hmmm, that phrase sounds familiar). They claim that due to novel factors such as foreign central bank buying of longer-dated Treasuries, the yield curve has lost its predictive power. I'm not convinced. If the dynamics I've outlined above are a factor, it doesn't matter who is buying what. An inverted yield curve discourages credit creation regardless.

My other objection, while admittedly more general, has history on its side: "this time" is almost never different. If the curve inverts for real, instead of briefly flipping as it did today, it does not portend of good things to come for the nation's economy.

(category: )