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By New_Deal_democrat May 20, 2016 10:24 am
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No, the yield curve is NOT signaling recession

In the last week or so there have been a spate of articles - from the usual Doomer sources but also from some semi-respectable sites like Business Insider vans an investment adviser or two ,see here ( https://lplresearch.com/2016/05/19/is-the-yield-curve-signaling-trouble-... ) - to the effect that the yield curve is flattening and OMG RECESSION!!! Here's a typical Doomer graph - that draws a trend line that ignores the 1970s and neglects to mention that 2 of the 4 inversions even within the time specified don't fit:



I guess if we don't have record high spreads in about 20 years that will mean permanent recession.


Umm, no.


Historically the signal for a recession 12 to 18 months out has been an *inversion* of the yield curve.  But with the Fed stuck at or near the zero lower bound, the thinking goes, an inversion is impossible, so a flattening of the yield curve in which intermediate to long term rates are declining is close enough.


The problem with this thinking is that historically the yield curve inversion was across the board, where short rates were higher than intermediate rates, which in turn were higher than long term rates.  And while the Fed funds rate may be close to zero, the more intermediate term yields were never zero or insignificantly different from it.


So let's take a look at the yield spread between the 10 year bond and the 2 year bond:



In all recessions going back 60 years, this spread *always* inverted first.  It is not only nowhere near inversion now, it is actually well within its normal range of about 1% during economic expansions.  Put another way, the abnormality isn't the 10 vs. 2 year spread now, it is the abnormally large 10 vs. 2 year spread earlier during this expansion.


Now let's compare the 10 year bond vs. the 5 year bond:



Again, not only is the spread not inverted, the spread is as high as it was at all times, even during the height of expansions, before 1980!


Neither of these term spreads, which do not have the problem of the "impossibility of inversion" that existed with a Fed funds rate of effectively zero, are anywhere close to their historical recession signals.


Finally, let's look at the 10 year treasury yield vs. the Fed funds rate:



Again, there is no special tightness in this spread.  But if you insist of finding a problem going forward, here it is as shown by separately breaking out the two yields:



It's not unusual for 10 year yields to be rising as the Fed raises rates (viz. 1994 and 1999 ).  The 10 year yield only declines once economic growth has started to buckle.


Now here is a look at the last year:



The yield on 10 year treasuries has declined by about 0.5% since the Fed raised ratesby 0.25% in December. This is because the economy is already weakening.  Let's just suppose that the Fed goes ahead and raised rates 3 more times, to 1.0%.  If the 10 year yield simply declines by the same percentage, the yield curve will be inverted.  This is one of the most likely scenarios giving rise to the next recession.

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