The brief inversion of the 2s-10s US yield curve led to a rather
typical explosion of commentary discussing whether we are looking at a recession
in the US in the next 6-18 months. This commentary is mostly based on the
empirical evidence that yield curve inversions are the most reliable predictor
or US recessions.[1] This
raises the question ‘Why do yield curve inversions predict recessions?’.
Start with establishing what do yield curve inversions
predict almost for sure: yield curve inversions are market-based
predictions of future decrease in short term interest rates. Since yields of
different maturity are equal to expected value of short term interest rates
over the length of given maturity, then decreasing yield curve has to imply
that market expects short term interest rates to be lower at some point in time
in the future.[2]
With this established, the question then becomes why would an
expected future decrease in interest rates be a predictor of a future
recession. At a first glance, it seems obvious: recessions are associated with
a decrease in interest rates. In modern economies this is because central banks
decrease nominal interest rates to fight recessions; but even outside of modern
economies, this should be the case, as recessions decrease demand for
investment/consumption, and hence decrease the natural rate of interest.
However, this answer provides only a partial justification for
why do yield curve inversions predict recessions. While expected future recessions
should imply downward sloping yield curves, this does not mean that downward
sloping yield curves necessarily imply recessions: necessary condition is not
the same as a sufficient condition.[3]
In other words, a future decline in interest rates does not necessarily mean a
full recession, defined as outright decline in economic output. This is
especially if one considers nominal interest rates in current environment: for
example central banks in CEE have increased policy rates to extremely high
levels to fight a bout of inflation, causing inversions in yield curves.
However, local market yield curves are just predicting that interest rates
decrease towards their long-run equilibrium values, and not below those values,
consistent with central bank’s expectations that policy rates will be gradually
normalized, reaching the long-run equilibrium levels from above. Therefore, an
inversion is not signaling a recession.
The example of CEE countries holds a more general lesson: expected
decrease in short term interest rates does not equal a recession, as short term
interest rates can decrease outside of recessions. For example, central banks
might orchestrate a yield curve inversions if they intentionally temporarily increase
short term interest rates above their long-term equilibrium values. Or more
generally, natural interest rates might decrease in absence of outright recession,
in case of what is often called a growth recession: a temporary decline in the growth
rate of the economy without an outright decline in output. A prime example was
the 2019 inversion in yield curve, which was prompted by the economic slowdown caused
by Trump’s trade war. While we will never know for sure, it is quite likely
that if it was not for the pandemic, the US economy would experience just
period of slower growth without an outright decline in output.
Turning to today, while there are good reasons to worry
about recession in US, there is a good chance why yield curve inversion might
not a be signal of one: the Fed is explicit that it wants to increase short
term interest rates above the long-term equilibrium values. This alone should
imply a yield curve inversion, but one intentionally engineered by the central
bank. Of course, this policy might actually cause recession, which will then
just add to the mythology surrounding yield curve inversions.
[1] That
said, theorical considerations also do play a role: one can construct models in
which yield curve inversions cause, rather than just predict, recessions. I
will ignore this aspect here.
[2]
Strictly speaking, one could construct decreasing yield curve also by
postulating term premium that decreases with maturity. While not impossible,
especially in current environment with term premium compressed by regulatory
requirements and large balance sheets of central banks, this seems to be rather
an edge case. Moreover, argument carries less weight when one focuses on
changes in yield curve slope, rather than just the arbitrary metric of negative-sloping
yield curve: even if long-term yields are compressed due to compressed or even
negative term premium, it should still hold that decrease in the slope of yield
curve implies that short term rates are either expected to increase less, or to
outright decrease. Similarly, the argument does not apply to the near-term yield
curve spread, since there term premium plays limited role.
[3]
Moreover, downward sloping yield curve is clearly not even a necessary condition:
while one would generally expect downward sloping yield curve ahead of predictable
recession, this of course does not apply to unpredictable recessions, and most
recessions are thought to be unpredictable. Case in point was the pandemic
recession, which was clearly unpredictable 6-12 months ahead of time. From this
perspective, it actually seems odd that yield curve inversions are such a reliable
predictor of recessions: it is as if something that is thought to be mostly
unpredictable is being reliably predicted.
