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What Inverted Yield Curves May Tell Us

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What Inverted Yield Curves May Tell Us

Highlights

- The inverted yield curve (10-year/three-month) has been considered the best predictor of every oncoming recession for 50 years, inverting before each recession with no false positives.

- If the Fed continues to move policy to a slightly restrictive stance, with a quite low term premium, the U.S. will likely see an inversion as soon as early next year.

- While not in S&P Global Economics' baseline prediction, if the fiscal stimulus leads to more inflation, rather than more productivity, the U.S. would witness slower growth, while hotter inflation would likely force the Fed to tighten the U.S. economy into an accident.

- Market participants--even economists at the Fed itself--disagree about whether the inverted curve has lost its predictive power. Though the yield curve's crystal ball may be cloudy today, S&P Global economists caution that markets risk ignoring the curve at their peril.

Sep. 24 2018 — With the U.S. economy on solid footing and looking to extend the expansion another year, helped by spending from Uncle Sam, it's hard to imagine a recession could be on the horizon. However, the currently flat yield curve has caused some to worry that if the curve inverts, the good times could soon end.

For the moment, the 10-year U.S. Treasury note yield (2.9%) remains safely above the three-month bill (2.1%), though it is close to the two-year yield (2.6%) and could grow closer sometime this year or next. Why should that matter? Because over the last 50 years or so, the 10-year/three-month yield curve has been one of the best leading indicators of recession.

The flattening yield curve, on its own, shouldn't be a surprise. That is what normally happens during tightening cycles, and there was no reason to think it would be different this time. We at S&P Global don't see the flattening so far as warning of a recession, but we believe it's a metric that bears watching as it veers closer to inversion. The track record of the 10-year/one-year spread, for example, has inverted for all of the last nine recessions--back to when the data start in 1953.

Assuming inflation expectations remain subdued in 2018, the term premium remains low, and the Fed continues to raise rates as it has proposed, an inverted yield curve becomes more likely, as soon as in 2019. If history still rings true, a recession does not happen overnight. The lead times for recessions following inversions have been inconsistent. The first inversion (10-year/three-month bond equivalent) has occurred from six to 15 months before the beginning of the recession, with an average 9.7 months back to 1953. (Using three-month constant maturity, the first inversion occurred from seven to 10 months, with an average of eight months.)

With the curve threatening to cross that threshold today, the debate on its merits has returned. Has the inverted yield curve lost its predictive power? Or does it still pack a punch? Just as in 2006, market participants--even economists at the Fed itself--are questioning whether the inverted curve has lost its ability to signal the direction of the economy. And while we recognize that correlation is not causation, we caution that markets risk ignoring the direction of the curve at their peril.

It may be easier to consider an inverted curve as a symptom, not the disease. While not in our baseline forecast, one risk to the expansion could be that financial stability concerns may appear long before inflation heats up. Another potential threat to the expansion's health could be the wind-down of the fiscal stimulus in 2019, which could lead to more inflation pressure for the Fed to fight instead of more growth-generating productivity. In that scenario, if it sees inflation heating up faster than previously expected, the Federal Reserve would be forced to hike rates faster than it had anticipated and what is currently priced into markets--with the expansion killed as collateral damage. Assuming that the yield curve does invert in 2019, it would once again score another run.

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