After months of anticipation, the U.S. Federal Reserve (Fed) has finally begun what is expected to be a series of numerous hikes to the target of their overnight fed funds rate. The rate is highly scrutinized because interest rates have an important impact on the economy, as well as serving as a central barometer for the overall health of the economy. As vital as interest rates are, however, it is important to consider what they can tell us, as well as what they can’t.
The Shape Explained
One closely followed signal is the shape of the U.S. yield curve, which shows how long-term interest rates differ from short-term rates. In general, when the curve is flat (meaning that long-term yields are similar to short-term yields), it suggests that the market believes future economic growth may be low relative to current growth, or even negative. It also makes long-term borrowing cheaper for both consumers and businesses. Finally, because the U.S. rates market is such a liquid and efficient market, many observers will look at yield curve inversion—that is, when longer rates fall below short-term rates—as a key indicator of an upcoming recession.
However, we note several key points regarding this relationship: first, yield curve shape does not actually cause recessions, although it may help to signal them; second, this indicator is far from perfect, as there have been numerous false signals in the past, with a varying amount of time until a recession may occur; and finally, it is important to consider which part of the yield curve is sending the signal, as some are more reliable than others.
As stated earlier, the shape of the yield curve does not cause recessions. In fact, all else being equal, a flat or inverted yield curve tends to boost economic activity, as borrowing costs fall for consumers and businesses alike. However, this shape does receive a lot of attention every time the yield curve flattens, as such a move is often associated with recessions. As we have written recently, a flattening of that yield difference is quite normal when the Fed is hiking. Indeed, such a move can generally be associated with economic health, as it implies that future economic expectations are similar to current economic activity, and that investors are not demanding a significant premium for uncertainty. And when that relationship inverts, it suggests the market believes that rates will fall in the future, likely due to sagging economic activity.
But in making such an assessment, we also must ask what part of the yield curve are we considering and how far in the future? And to which short-term rates are we comparing things? The oft-cited metric of two-year U.S. Treasury yields versus 10-year U.S. Treasury yields, it turns out, is both vague and unreliable. A better indicator, the difference between very short-term yields and medium-term Treasuries, such as three-month and five-year U.S. Treasury yields, provides a far more reliable signal for recession risk.
Finding More Reliable Yield Curve Signals
One problem with some yield curve indicators is that they can give false signals. The U.S. economy has experienced four recessions since the last time the Fed had to use policy to battle stubborn inflation—when Chairman Paul Volcker spearheaded a series of hikes in the early 1980s. During that period, the yield difference between two-year Treasuries and 10-year Treasuries has gone from positive to negative seven times—or seven recession signals for only four recessions, including the “successful” inversion prediction of 2019 that likely would have been another false signal without the COVID-19 pandemic.
In addition to false signals, the two-year and 10-year Treasury yield spread inversion tell us very little about when the recession might occur. The handful of correctly predicted recessions have ranged from six months to more than two years after the inversion occurred. For example, the yield curve inverted in January 2006 and stayed inverted for more than two years until the recession of the financial crisis in 2008. There are simply to many factors that determine the yield on a 10-year Treasury for it to tell us anything meaningful about long-term forecasts. However, we can look to a more reliable recession signal if we consider short-term maturities.
