The yield curve is first and foremost predicting the outlook for Fed policy rather than the next recession. My research has confirmed this...
The yield curve is first and foremost predicting the outlook for Fed policy rather than the next recession. My research has confirmed this conclusion, as does a recent Fed study.
In my recent book, Predicting the Markets, I wrote: “The Yield Curve Model is based on investors’ expectations of how the Fed will respond to inflation. It is more practical for predicting interest rates than is the Inflation Premium Model. It makes sense that the federal-funds rate depends mostly on the Fed’s inflation outlook, and that all the other yields to the right of this rate on the yield curve are determined by investors’ expectations for the Fed policy cycle.”
More specifically, after studying the relationship between the yield curve and the monetary, credit, and business cycles, we have concluded that it is credit crunches, not inverted yield curve, and not aging economic expansions that cause recessions. The yield curve is just keeping score on how the Fed is reacting to and influencing these cycles. So why do inverted yield curves have such a good track record in calling recessions, and could it be different this time?
According to a July 2018 Fed study about the yield curve, the probability of a recession was around 14%. However, a February 2019 update of this study reported that the odds had risen to 50%. That recession warning might have contributed to the remarkable pivot from a hawkish to a dovish stance by the Federal Open Market Committee (FOMC), which sets the Fed’s monetary policy.
The Fed recently signaled that there won’t be any rate hikes this year and only one next year. If so, this should reduce the chances of a recession. Let’s have a close look at the Fed study, which confirms our view about the best interpretation of the yield curve:
1. Original note: Last year, the minutes of the June 12-13 FOMC meeting offered a reason not to worry about the flattening yield curve at that time. During the meeting, Fed staff presented an alternative “indicator of the likelihood of recession” based on research explained in a June 28 FEDS Notes titled “(Don't Fear) The Yield Curve” by two Fed economists, Eric C. Engstrom and Steven A. Sharpe. In brief, they questioned why a “long-term spread” between the 10-yearTMUBMUSD10Y, -0.89% and two-year TMUBMUSD02Y, -1.90% Treasury notes should have much power to predict imminent recessions. As an alternative, they devised a 0- to-6-quarter “near-term forward spread” based on the spread between the current level of the federal-funds rate and the expected federal-funds rate several quarters ahead, derived from futures market prices (Fig. 1).
The authors stressed that the long-term spread reflects the near-term spread, which they argue makes more sense as an indicator of a recession that is expected to occur within the next few quarters. They also observe that an inversion of either yield spread does not mean that the spread causes recessions.
At the time, their assessment was that ‘the market is putting fairly low odds on a rate cut over the next four quarters,’ i.e., 14.1% (Fig. 2). “Unlike far-term yield spreads, the near-term forward spread has not been trending down in recent years, and survey-based measures of longer-term expectations for short term interest rates show no sign of an expected inversion,” they observed. In our commentary last year, we concluded: “What a relief! So now, all we have to worry about is a recession caused by a trade war!”
2. Updated study: The updated Fed study dated February 2019 has a less jazzy title: “The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted Mirror.” The authors observe that their near-term spread “can be interpreted as a measure of the market's expectations for the near-term trajectory of conventional monetary policy rates.”
In addition, they report: “Its predictive power suggests that, when market participants expected — and priced in — a monetary policy easing over the subsequent year and a half, a recession” was likely forthcoming. The near-term spread “predicts four-quarter GDP growth with greater accuracy than survey consensus forecasts. Furthermore, “it has substantial predictive power for stock returns,” find the Fed economists. In contrast, yields on bonds “maturing beyond 6-8 quarters are shown to have no added value for forecasting either recessions, GDP growth, or stock returns.”
3. A highly hedged warning: Buried on page 7 of the new study is a warning that the probability of a recession had increased significantly since the original study was done about a year ago: “As of the end of the sample period in early 2019 (and the time of this writing), the near term forward spreads forecast a substantially elevated probability of a recession.”
Indeed, Figure 3 in the study clearly shows that recession risk jumped to 50% (based on first-quarter 2019 data available only through January). Interestingly, this important update wasn’t mentioned in the summary paragraph at the beginning of the study. However, the charts in the paper show that the odds of a recession increase most significantly when the near-term forward spread is markedly below zero, which it was not as of the most recent analysis.
The Fed isn’t likely to be raising the federal-funds rate over the next 12 months
Accordingly, we’re not freaking out about an impending recession. We are focusing on the idea promoted in the Fed study (and in my book) that the yield curve first and foremost is predicting the outlook for monetary policy. For example, the paper noted that “the near-term forward spread would tend to turn negative when investors decide that the Fed is likely to soon switch from a tightening to an easing stance.”
The yield-curve spread tends to narrow during periods when the Fed is raising the federal-funds rate (Fig. 3). It tends to bottom and then widen when the Fed starts to lower interest rates. It just so happens that past recessions occurred after the yield curve inverted, i.e., at the tail end of monetary tightening cycles.
It might be different this time, if the Fed has paused on a timely basis from raising interest rates any further, thus reducing the chances of a recession. After all, there’s no need to overdo tightening given that inflation and speculative excesses remain subdued. In the past, Fed tightening (not inverted yield curves that coincided with tightening) led to financial crises, which morphed into widespread credit crunches, resulting in recessions (Fig. 4).
Hence our conclusion that it is credit crunches that cause recessions, not inverted yield curves and not aging expansions.
4. False-positive signal: Drawing parallels between monetary policy in 1998 and today, Engstrom’s and Sharpe’s paper stated: “The most prominent false positive during our sample came with the anticipated easing triggered by the spread of the Asian financial crises in 1998, which did not result in a recession in the U.S. It is not hard to imagine that similar scenarios could generate additional false positives in the future. The near-inversion of the near term forward spread at the end of 2018 seems to have been associated with market perceptions of significant risks to the global economic outlook, including the threat of escalating trade disputes. Whether those risks manifest in a recession remains to be seen.”
5. Missing in action: The Fed study notes: “We define the near-term forward spread on any given day as the difference between the implied interest rate expected on a three-month Treasury bill six quarters ahead and the current yield on a three-month Treasury bill.”
According to Haver Analytics (our data vendor): “We had been in touch with the Board about the 0-to-6 Quarter Forward Spread earlier this year and they had told us they calculated it using an internal fitted zero coupon curve in quarterly maturities. They only make annual maturities available at the moment so we cannot calculate.”
6. The two-year yield curve: So instead of trying to calculate the Fed study’s near-term spread, we will focus on the 12-month forward futures for the federal-funds rate, which is available daily (Fig. 5). The two-year Treasury note yield tracks this series closely, suggesting that it is also a good proxy for the market’s prediction of the federal-funds rate a year from now.
7. Pause prediction: After all that work, the conclusion is the obvious one: The Fed isn’t likely to be raising the federal-funds rate over the next 12 months. Last Monday, the 12-month forward rate was 2.06%, 32 basis points below the 2.38% midpoint of the federal-funds rate target range. The two-year was 2.24%, 14 basis points below the midpoint late last week.
The Fed study suggests to us that the spread between the two-year Treasury yield and the federal-funds rate may be the simplest way to track the fixed-income market’s outlook for monetary policy over the next 52 weeks (Fig. 6). Anyone can do this at home. But that doesn’t mean that the market will be right, as evidenced by how wrong it turned out to be last year.
The bottom line: For now, we still don’t see a significant risk of a recession, especially since the FOMC remains “patient.” The committee’s recent decision to pause hiking the federal-funds rate over the rest of this year reduces the risk of a financial crisis triggering both a credit crunch and a recession.
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