The US bond yield curve inverted recently, with the spread between three-month and 10-year US Treasuries falling to below zero for the first time in more than a decade. In this white paper, Richard Barwell explains why, contrary to received opinion, such an inversion is not a reliable signal of an impending recession.
The credentials of the yield curve as a ‘super-forecaster’ of recessions should be treated with scepticism. At best, the yield curve is a mirror that reflects what we already know, or think we know, about the economy.
The slope of the yield curve and whatever message it sends about recessions risks should therefore reflect nothing more than the market’s considered assessment of public information on economic fundamentals or the conduct of economic policy, for example; and potentially much less.
This mirror image is likely distorted, offering an inaccurate view of the true state of the macro outlook because the slope of the yield curve is also driven by other factors, unrelated to the risk of recession.
There is no plausible, stable mapping between a percentage point increase in the perceived (or actual) probability of a recession and the slope of the yield curve; be it the corresponding shift in either expectations of short rates or the term premium.
The only reason to ignore fundamentals and focus instead on their reflection is if you believe that bond investors are better at economics than economists – that the slope can partially reveal the superior forecasts of those investors.
In any case, it seems unlikely that a market where prices are increasingly driven by global investors and global factors can speak authoritatively on local developments. Moreover, the very shift in the shape of the yield curve that supposedly sends a signal of looming recession reduces its likelihood by stimulating demand.
The real risk of recession may arise in ‘tantrums’: when the yield curve decouples from fundamentals and there is an unwarranted increase in medium to long-term yields that will depress activity.
We accept there are reasons to be concerned about the outlook for demand at the global level, but we maintain that investors are better off forecasting recessions by thinking about fundamentals and discussing with economists than excessively analysing the distorted reflection of fundamentals in the yield curve mirror.
Richard Barwell is the Head of Macro Research at BNP Paribas Asset Management. His team is responsible for producing market relevant research, including: analysis of high frequency news, market developments, upcoming policy decisions and political events; and producing macroeconomic scenarios, thematic research and trade ideas. Prior to joining us, Richard worked at the Royal Bank of Scotland and at the Bank of England for almost a decade. He holds a PhD in Labour Economics from the London School of Economics and Political Science. Richard has written several books on economic policy and published a number of articles on this subject.
Please note that this document may contain technical language. For this reason, it is not recommended to readers without professional investment experience.