- by New Deal democrat
No big economic data today. So let’s take a look at a significant forecasting tool. Some leading indicators are very good. But none is infallible. And the last few years have slain one of the most-touted for infallibility: the inverted yield curve.
For those who need a brief refresher, typically the longer the term of a bond, the more interest an investor will require for taking the risk of lending their money to the borrower for a longer period of time. Thus we typically expect a 30 year Treasury to yield more than a 10 year, and both to yield more than a 5 year, all three to yield more than a 2 year, and all of the above to yield more than a 3 month Treasury bill. That is called a normal, or regularized, yield curve.
But sometimes - typically but not necessarily always when the Fed is raising interest rates - the yield curve behaves abnormally, with some shorter duration Treasuries like the 3 month or 2 year durations paying more interest that longer duration Treasuries like the 10 year. That is called an inverted yield curve.
And for the past 50 years, it has been thought that an inverted yield curve means recession ahead.
Until now.
First, let me show you the historical record of the two most common measures of the yield curve: the 10 year minus 2 year treasury yield (blue) and the 10 year minus 3 month yield (red) since 1980:
The former measure doesn’t go back further, but the 10 year minus 3 month can be charted all the way back to the early 1960s:
So let’s summarize what we see. With the exception of the COVID lockdowns, which may never have been a recession otherwise, before every recession in the past 60 years, both measures of the yield curve above had inverted. About half the time, the 10 year minus 2 year had also re-normalized before the onset of the recession. And so in most cases had the 10 year minus 3 month comparison.
Astute observers will note that on one historical occasion there was a failure: during the 1966 “guns & butter” economy of LBJ, there was an inversion but no recession for another 3.5 years.
And, as I will document below, there has been a failure in this decade as well.
The 10 year minus 2 year metric has almost always inverted first. The shortest period of time between inversion and recession has been 10 months (1980) while the longest has been 19 months (1990). The median period has been 15 months.
But the 10 year minus 2 year spread inverted in July 2022, a full 50 months ago (and counting). That’s almost triple the amount of time between the longest previous period of inversion to recession.
Similarly, going back to the 1960s, the shortest period of time between inversion of the 10 year minus 3 month spread has been 8months (2001) while the longest has been 25 months (1980). The median period has been 13 months.
But this decade the 10 year minus 3 month spread inverted in November 2022, 38 months ago, 1.5* more than even the longest such time in the past 50 years.
But, some have said, the real danger point is after the spread has re-normalized, pointing to all of the past times when a recession has begun after that normalization.
To begin with, about half the time no such re-normalization has occurred. So this metric appears to be random noise. But further, it relies upon an unstated assumption that the yield curve inversion is infallible. In other words, once there is an inversion, the recession will come either before or after a re-normalization, but it *must* come.
Well, certainly there is always another recession in the future *sometime,* but let’s see how this metric pans out as well.
The 10 year minus 2 year spread only un-inverted 3 times before recessions: by 2 months in 2001, 4 months in 2007, and 9 months in 1990. But this decade it un-inverted in August 2024, 25 months ago - almost 3* the maximum previous length of time.
And the 10 year minus 3 month spread un-inverted 7 previous times, with a duration of 1 month before at the least (2001) and 6 months before at the most (1990 and 2007). But this time around, measured monthly, it un-inverted in December 2024, 21 months ago, more than 3* the maximum previous duration. Even measured weekly it has been un-inverted for almost 12 months.
Only if we include the 1966 inversions and date them in comparison with the 1970 recession can we find any analogy, for the 10 year minus 3 month spread could be said to invert 42 months before the recession, and un-invert 25 months before. At present we are already past the former period, and only 4 months away from the latter. I submit that a “leading indicator” that takes almost half a decade to come to fruition is not an indicator at all.
So, if the inverted yield curve is busted as an infallible indicator, do I still plan to track it? Yes, because its past record is still good, and I use it only as part of a constellation of such indicators with good records that go back many years.
In which regard, let me give you the same graph, but over the past two years:
While the 10 year minus 3 month spread has continued to widen, the 10 year minus 2 year spread has narrowed again, most recently briefly to only 0.25%. Keep in mind from the above that the 10 year minus 2 year has almost always inverted first. And once it has narrowed to only 25 basis points, it typically has gone on in the near future to an inversion.
In other words, while the yield curve, like every other indicator, is not infallible, in a few months the clock might start ticking again.
