“[O]Their minds are strongly biased towards causal explanations and do not deal well with ‘mere statistics.’” – Daniel Kahneman,
The predictive power of the yield curve is a widely accepted causal narrative. However, the history of the yield curve shows that the causal relationship between long and short rates of interest is definitely quite weak. While long and short rates of interest are likely to move in the identical direction, they achieve this at different paces.
The debut of the Federal Reserve System in 1914 and the emergence of contemporary central bank orthodoxy amid the good inflation of the late Sixties to early Nineteen Eighties contributed to a divergence in the way in which the market sets long-term and short-term rates of interest. The yield curve’s predictive accuracy was significantly inconsistent in the primary half of the twentieth century, but was far more reliable within the second half – a shift consistent with the Federal Reserve’s performance over time.
During the nineteenth century and the primary three a long time of the twentieth century, yields on four- to six-month industrial paper were, on average, higher than the yields on high-quality long-term bonds. As the US Civil War gave technique to peace and deflation, rates of interest trended downward. But across the turn of the century, gold discoveries increased the cash supply and caused rates of interest to rise. During this era, the market set rates of interest based totally on the provision and demand of loanable funds. The low rates of interest of the post-Civil War era failed to stop eight separate NBER recessions between 1868 and 1900.
But even higher rates of interest from 1900 to 1920 didn’t have much impact on the economy, as there have been six different NBER recessions within the 20 years. A persistently inverted yield curve can have contributed to the high frequency of recessions. A negatively inclined rate of interest structure creates a negative incentive for long-term investments.
Only after 1930 did positive yield curves turn out to be more regular. The stock market crash of 1929, the resulting shift toward greater government economic planning, and the combination of Keynesian economic policies later within the Nineteen Thirties undoubtedly led to a shift within the slope of the yield curve. When short-term rates of interest got here onto the radar of economic policymakers, they introduced a brand new causal force that broke the link between short and long rates of interest.
Because markets had the chance to set long-term rates of interest, policymakers and the market’s views on the state of the economy diverged. The Fed’s open market operations are countercyclical in nature and lag the true economy. The market, alternatively, is a forward-looking voting machine that represents the collective wisdom of the masses. When the market believes the Fed is being too hawkish, long-term rates of interest fall below short-term rates of interest. If the Fed deems them too dovish, long bond rates will rise well above their shorter bond counterparts.
Market prices are the very best indication we’ve got of future market outcomes. Why? Because of the possible rewards. If the long run will be predicted in any respect, prices in a free market are probably the most effective crystal ball: resources are deployed in a way that exploits any mispricing. In earlier times, financiers didn’t recognize the connection between long-term and short-term rates of interest. They viewed short-term lending primarily as a matter of return on capital and long-term lending as a matter of return on capital. But the mix of Keynesian economic policy and the market’s discounting mechanism made the yield curve the forecasting tool it’s today.
But it have to be used with caution. It’s not only the slope of the curve that matters, but additionally the way it develops and the way long the curve is inverted.
Cumulative days of yield curve inversion
Source: Federal Reserve Bank of St. Louis, NBER
According to the chart above, the yield curve has inverted from positive to negative 76 times since February 1977 – sometimes for months, sometimes for only a day – but there have been only six recessions. Therefore, the reversal alone is hardly an accurate oracle. Only when the market and the Fed drift apart over an extended time frame and the market expects significantly lower growth than the Fed does the market’s recession expectations are likely to come true. Given the efficiency of the market voting machine, this could hardly be surprising.
The yield curve is a preferred recession indicator for good reason. But we’d like more evidence of its effectiveness, especially when signals suggest that Fed policy is just too loose.
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Photo credit: ©Getty Images/ ardasavasciogullari
