A Macronote on the Yield CurveIn this week’s short Macronote, Roger decided to return to a subject he has touched upon many times before: ‘this time is different’. But when it comes to the feared yield curve inversion he actually seems to mean it.
A couple of weeks ago, there was a lot of discussion on a SF FED economic letter on the yield curve spread, a theme that I have touched upon a couple of times before. One thing that apparently caught a lot of people’s attention was that the seemingly best indicator is the 3m-10y interest rate spread rather than the 2y-10y spread. To readers of this blog that was nothing new and I draw a lot on the reasoning here, not only from recent FED-speeches but also from our blog-discussion back in February: “What just happened”.
This time around I thought we could briefly discuss if “this time is different” as many FED-officials and well-known FED commentators seem to believe. To be honest, and despite having a reputation of being pessimistic, I share FED Governor Brainard’s views on this and see inversion more as a historical observation that deserves interpretation, rather than something that in and of itself necessarily causes or signals a recession.
First and foremost, it is important to note that the term spread is currently under the influence of “institutional” forces. Not only has the change in the tax system implied lower tax deductibility (from 35% to 21%) held down government rates, but FED’s still high liquidity and simultaneous hiking of short rates probably also distort the signals from the interest rate structure.
Secondly, and perhaps more importantly, I think we should at least stop to consider why the yield curve has flattened and is now even close to inversion. Does the information content somehow differ to previous episodes of yield curve inversions?
What is clear from the above chart is that since the great moderation at least, yield curve inversion preceding a recession taken place in an environment where long yields have fallen or at least have been stable. The greater long rate stability probably comes from monetary policy supplying an improved nominal anchor, reducing inflation volatility and risk premia (i.e., rates).
Currently, the trend in long yields is still upwards, an environment that neither has produced an inversion nor signaled a recession. – Almost to the contrary, when we see ‘parallel’ shifts of any magnitude in rates it is more a reflection of improved economic prospects. Let’s have a look at how (if?) the above discussion is reflected in real yields and if there are possible (not probable) changes in inflation expectations that could be at play.
Unfortunately, as the indexed-link market is quite a recent innovation, we only have data covering the past two recessions. Also, in the US we don’t have generic data on shorter term index-linked (real) bonds. From the early 2000s and onwards inflation expectations seem to have stabilized (noticeable also in other inflation expectations measures) which rhymes well with the general idea of the great moderation ending around that time. Real yields, to the contrary, have become more volatile, and it is interesting (not surprising) to see the pattern of falling real yields in the run-ups to the two latest recessions.
It also underlines Brainard et al.’s and my semi-optimistic view of this time being different, at least in terms of overall yield curve developments. Studying the period since 2015/16 demonstrates that we have seen almost a 1:1 shift in both 5- and 10-year break-even inflation (BEI) expectations and also a clear upward trend in real yields reflecting the improved economic outlook.
A perhaps speculative, but still interesting observation is that while 5-year real yields has pulled down 10-year real yields ever since the end of the great recession, we now see a resurgence of 5-year real yields exceeding 10- year real yields. Could we read this as a sign of a more pronounced optimistic shift in longer terms real yield (real growth!) as well?
Anyhow, there is very little in this latter discussion that rhymes with developments before the past two recessions. Inflation expectations are now in line with the inflation target and expectations on real yields, especially short term, are rising suggesting that times are improving rather than deteriorating.
To conclude, an inversion of the yield curve has been an uncannily well working indicator of recessions. That said, a flatter yield curve under rising short- and long-term nominal and real yields suggest that this time is indeed different.
To be continued.
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