Decoding The Yield Curve Talk – Fed Will Save the US

A lot of yield curve spread data doesn’t help much.

Recession, a very scary word in the world of economics, has been receiving great public attention these days. As the history suggests, the possibility of recession increases significantly of the yield curve inverts – when the short-term interest rates becomes higher than long-term rates.

Many analysts have been trying to portray the curve inversion as the reason of the recession and that might be the case also, but many of those analysts have using data as per their convenience and rhetoric. Some analysts who are most vocal about the upcoming recession are using the difference between 30-year and 5-year, 10-year and 2-year and many such other pairs to come to their desired conclusion.

Explaining the terms of yield curve:

A term spread is the basic difference between a long-term and a short-term interest rate. Most commonly used term spread is difference of 10-year and 2-year treasury yields as it captures both long-term perceptions and sentiment of bond market investors and short-term stance of monetary policy. However, the US Federal Reserve has clarified that the spread between the ten-year and three-month Treasury yields (10y–3m) makes more sense as it captures short-term stance of monetary policy in a more precise manner. Recently Engstrom and Sharpe (2018) concluded through their research that the difference between the six-quarters-ahead forward rate and the three-month yield (forward6q–3m)—might be the predictor of recession as emphases on expectations of the near-term stance of monetary policy.

Fed researchers Michael D. Bauer and Thomas M. Mertens did a thorough analysis on the current situation of these yield curve spread.

Yield Curve
Source: US Fed

The figure above clearly indicates the impact of these different spread and yield curve inversion. All three curves inverted generally a year or two before the recession. Recent trend suggest that due to continued decline in the long term yield, these yield curves are on the verge of inversion.

Yield Curve

The 10y–2y, 10y-5y, 10y-7y and 5y-2y spreads are very near to critical threshold of zero, while the most Fed recognized 10y–3m spread is at 0.73%, conformably above the critical threshold of zero.

Read: Making Sense of the Strend in the US dollar

The Fed also analyzed the predictive power of these spreads and concluded that 10-year and 3-month spread provides the maximum accuracy as per the chart below.

Yield Curve

Thus, I would humbly request everyone to understand that 10-year and 3-month spread is still comfortably above the critical threshold of zero. Let us not kill the amazing indicator of recession by using wrong spread.

Yield Curve

The yield curve has been a reliable predictor of recessions, and the best summary measure is the spread between the ten-year and three-month yields. Although this particular spread has narrowed recently like most other measures, it is still a comfortable distance from a yield curve inversion.

Additionally, one should also understand that cost of capital has not risen too much and credit availability has not declined, meaning the recessionary situation might be far from now.

Let us try to thing about the road ahead from here:

The restrictionary environment that we witnessed before the recession has not been seen this time. The US Federal Reserve has projected a lot more hikes till 2020 indicating that with benchmark interest rates might move above 3% and then it might move to a neutral monetary policy stance. This would certainly mean the flattest ever yield curve (10y-3m) or even if it inverts but at the same time neutral monetary policy would never let the US fell into recession.

So let us not jump the guns and predict a recession. The Fed will save the US just like it did in 2008.

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