Last October, we discussed a commentary by Patrick Harker, the President of the Philadelphia Federal Reserve, on the importance of the US Yield Curve as an indicator of future US recessions.
Harker had said that the Open Market Committee of the Federal Reserve needed to keep an eye on the shape of the yield curve as the Fed tightened monetary policy. He suggested this might aid the Fed to tighten more slowly, so as not to provoke another US slowdown.
We examined the data for the period 1982 to 2017. We found that Harker was correct. Using a measure of the yield curve as US 10 year bond yields minus 90 day bill yields, we found that variation in the shape of the yield curve had a 100% success rate in predicting US recessions since the early 80's. We found that the yield curve did not have to fall below zero to forecast a recession. It was sufficient for this measure of the yield curve to fall below 0.5%. This level was particularly relevant in the late 1980's and early 1990's. It was at this time that a modest slowdown in the US economy, caused by a crisis in US "savings and loans" (similar to Australian building societies), began a US slowdown which provoked the Australian recession of the early 1990's.
What was different over the time period was the lag between this inversion in the yield curve and when a US slowdown occurred. In the data before the year 2000, an inversion of the yield curve appeared to lead to a US slowdown after a period of around five quarters. After the year 2000, an inversion in the US yield curve appeared to lead to a US slowdown after a period of around nine quarters.
In January, I went to a presentation by Patrick Harker in Philadelphia. I asked Harker about his comments on the yield curve. He said that the shape of the US yield curve was a very strong indicator of a future US recession. However, he said there was no clear explanation of how this indicator worked.
Is the next US recession in sight?
The Federal Reserve has been tightening for almost two years. How close are we to the yield curve telling us a recession awaits? In Figure 1 above we see the US yield curve for the period from 1982 to 2018. The US yield curve, which peaked at around 3.7% in April 2010, has been tightening progressively since. This tightening began even before the Federal Reserve began to increase the Fed Funds rate.
Since 2016, the Fed rate hikes have been followed by an increase in 10 year bond yields. 10 year bond yields have been losing the race with the Fed Funds rate. This means that the yield curve has been declining. On Monday 18 June, our measure of the yield curve had fallen to 98 basis points. Still, 98 basis points is above our precautionary level of 50 basis points, which signals a future US recession.
The current shape of the US yield curve does not signal a coming US recession. Should the Fed continue to tighten at the current pace, this signal of a forthcoming US recession might be apparent by early next year.
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