The next time a U.S. recession hits, what has traditionally been a reliable harbinger of an economic slump may end up being the dog that didn't bark.
The shape of the U.S. yield curve--specifically, the spread between 10-year and three-month Treasury yields--is often used by economists and investors to gain insight about what's in store for the world's largest economy.
Typically, when yields on longer-dated debt dip below shorter-term yields, it serves as a signal that market participants believe monetary policy is overly tight, and that the central bank will be forced to cut short-term rates to stimulate the economy.
For that reason, the so-called "inverted yield curve" is considered to be a leading indicator of a recession, and has delivered very few false positives over several decades:
For bears, crossing "yield curve" off the list of indicators that herald an economic downturn is, at present, a welcome development. According to JPMorgan Chase & Co., credit spreads and the decline in the S&P 500 imply a much higher probability of recession during the next 12 months than the spread between 10-year and three-month Treasury yields.
You can count Deutsche Bank AG Chief U.S. Economist Joseph LaVorgna among those who think the next U.S. recession won't necessarily be preceded by an inverted yield curve.
"The reason we caution against using the U.S. yield curve as a leading indicator is that short rates are still extremely low," he wrote.
LaVorgna turns to Japan as a case in point:
"Over the last two decades, the Japanese yield curve has flattened ahead of each of the last four recessions (1997 to 1999, 2000 to 2002, 2008 to 2009 and 2012). Yet in each case, it did not invert," the economist explains. "Consequently, we believe there is a high probability that whenever the next U.S. recession occurs, the 10s-funds curve is likely to remain positive, and perhaps significantly so, at least compared to past business cycles."
The comparison with Japan, however, falls short in some respects. Most notably, 10-year debt in Japan has never (save for one brief stretch last year) had a higher nominal yield than German bunds or U.S. treasuries of the same maturity over the time period examined by LaVorgna. Foreign private inflows are also capping how high yields can go at the longer-end of the U.S. curve, as continued quantitative easing by the Bank of Japan and European Central Bank spill over to the U.S and put downward pressure on Treasury yields:
The Federal Reserve's massive holdings of U.S. debt is another factor that muddies the water in terms of what investors can hope to discern from the spread between short and long-term Treasury yields.
Mark Dow, founder of Dow Global Advisors, suggested that, as a result, a flattening of the curve or even an outright inversion might not be harbingers of recession.
"The Fed involvement in the long end of the curve makes it not very useful, in my humble opinion, to try and extract much economic information from the curve shape," said Dow. "Changes in the curve shape tell you something about changes in psychology, but the level of slope probably doesn’t tell you too much—even [if] it were inverted."
In a separate report, the fixed income team at Deutsche Bank fleshed out some of the "structural limits" they believe keep the yield curve artificially steep with policy rates at their current low levels:
For example, liabilities-driven investors who in the past could receive long rates below the fed funds rate can no longer do so once rates are floored at zero. Investment fund managers are also restricted by mandates from buying negative yielding assets that lead to mark-to-market losses on their portfolios. Pension investors, who must target returns based on liability assumptions, have been driven into high yielding non-core rate assets as their discount rates are stubbornly and unrealistically high compared to Treasury yields.
After correcting the spread between the three-month and ten-year Treasuries for the low nominal policy rate, the probability of a recession in the next twelve months is a little less than a coin flip, according to Deutsche Bank.
But others maintain there's no reason to turn your back on the Old Faithful of recession indicators just yet.
"Either the yield curve is a combination of forward expectations and risk premium or it isn't; 'normalizing' to a level of short rates strikes me as an exercise based entirely on capricious judgment rather than empirically observed outcomes," wrote Bespoke Investment Group Analyst George Pearkes.
As former Fed Chairman Ben Bernanke explained in a 2013 speech, yields on government debt are governed by three factors: expected future inflation, the presumed evolution of central bank policy rates, and the term premium (compensation for adding duration).
Despite the rapid flattening of the curve in 2016, the spread of 1.61 percentage points between three-month and 10-year treasuries at the end of January remained 12 basis points above its long-term average.
"All I know is that it would be historically unprecedented for the curve to not invert on the eve of a recession," added Pearkes. "It's of course possible it doesn't. But based on the data in front of me, there's nothing I see that suggests bond market behavior similar to prior imminent recessions."