Recessions are like death – it’s not a matter of if they will happen, but when.
Morbid? Perhaps, but as Steve Jobs put it, “Remembering that I’ll be dead soon is the most important tool I’ve ever encountered to help me make the big choices in life… death is the destination we all share. No one has ever escaped it, and that is how it should be because death is very likely the single best invention of life. It’s life’s change-agent. It clears out the old to make way for the new.”
Similarly, markets will inherently follow cyclical rhythms of expansion, contraction, and the dramatic phase-shift jump from ‘alive’ to ‘dead’ during recessionary states. Rather than live in perpetual fear of these inevitable phase-shifts, the key is to have early diagnostics to help narrow the timing window. But how?
One tool that many people have historically used is the yield curve. A yield curve inversion has happened before every recession in the U.S. going back to the 1960s.
So, all we have to do is wait for the next inversion right? We will show that a yield curve inversion is neither a necessary nor a sufficient reason for there to be a recession, but as a single, standalone indicator for recessions, it has no better.
The yield curve plots the interest rates of similar debt instruments at different maturities. It is often represented by subtracting a long-term bond from a short-term bond, for example, the 10-year Treasury note minus the 3-month Treasury bill, as in the above chart.
The yield curve is typically upward sloping/positive because borrowers require higher interest rates for locking up their money for a longer period of time. However, on occasion the interest rate on longer-term bonds can fall below the interest rates of shorter-term bonds. This is called a yield curve inversion.
While the yield curve has inverted before every US recession since 1960, there were actually five consecutive recessions from 1935 to 1960 where the yield curve did not invert beforehand.
While this shows that a yield curve inversion doesn’t always precede a recession, this doesn’t invalidate the more recent predictive power of an inverted yield curve.
The yield curve is more predictive of recessions in some countries than others. While you see false positives in some countries (especially the UK), a yield curve inversion has typically occurred before recessions in other major countries as well since 1970.
Notably though, the yield curve hasn’t inverted before recessions in Japan since 1991.
It is likely not a coincidence that the lack of yield curve inversions coincided with Japan’s zero interest rate policy (ZIRP).
This brings us back to the US, which has held interest rates near zero since the financial crisis. We shouldn’t be surprised then if the yield curve doesn’t invert before the next recession. Also, if you look back at the second chart, the yield curve didn’t invert in the U.S. in the 30s when short-term rates were held near zero.
A yield curve inversion is neither necessary or sufficient before a recession. It is less likely to occur when short-term rates are low. Nonetheless, if the yield curve did invert, investors should be far more alert to the possibility a recession is as little as 6 months away.
The yield curve is less likely to invert before the next US recession given low rates. That’s why it’s important to look at a constellation of inputs when attempting to forecast the next recession.
That’s why we at Variant Perception have created a composite recession indicator composed of 12 separate sub-indicators and a variety of inputs that are based on thousands of academic studies and our own experience over the last 10 years. We used this in real time to tell our clients the US was already in recession in January 2008.
If you’d like to learn more, please click here to download our Understand Recessions white paper.