That Recession Forecast? Yield Curve Says No Way: Caroline Baum
Green shoots are proliferating in gardens across America, but for some forecasters it already looks like the end of summer. A few are even hinting at recession by year-end. That’s highly unlikely.
While black swans have gained a new cachet following the prices-can’t-fall-nationwide housing bust and the financial meltdown it triggered, the most important leading indicator, the yield curve, is saying there will be no recession anytime soon.
With the Federal Reserve’s benchmark rate at zero to 0.25 percent and the 10-year Treasury note yielding 3.06 percent, the spread between the two interest rates is among the widest in history. It’s the reverse configuration, an inverted yield curve with short rates above long rates, that augurs recession.
The spread -- or the "term structure of interest rates," as it’s known in academic circles -- isn’t some mystical talisman with omniscient powers. It derives its prognosticating ability from the simple fact that one rate is artificially pegged by the central bank while the other is determined by the market. Their relationship encapsulates the stance of monetary policy.
When the yield curve is steep, as it is now, it’s an inducement for banks to expand their balance sheets -- borrow short, lend long -- and increase the money supply. That bank credit isn’t growing now owes more to the hangover from a period of excess leverage and new-found religion on lending standards than any restrictive policy on the part of the Fed.
In a similar situation in the early 1990s, following another real-estate-driven banking crisis, it took years for financial institutions to start lending again.
The Curve Inverts
The time to worry about recession is when the Fed raises the funds rate to the point where the yield curve inverts. Within a year or two, it’s curtains for the economy.
The yield curve is one of 10 components of the Index of Leading Economic Indicators. It wasn’t added to the LEI in 1996 on a random role of the dice. It’s in there because it has proved to be a reliable predictor of the economy.
Not only that. Historically the yield curve has been the first of the leading indicators to signal a turn in the business cycle, according to economists at the Conference Board, the keeper of the LEI.
The typical lead time is 15 to 16 months at the business cycle peak and nine months at the trough, according to Ataman Ozyildirim, associate director of the U.S. and global indicators program at the Conference Board. With the spread currently about 300 basis points and the Fed in no hurry to raise short-term rates, recession isn’t in the cards.
In the most recent business cycle, the fed funds rate first rose above the 10-year Treasury yield in June 2006. The recession started in December 2007, which gave doubters 18 months to protest that "this time is different" before an inverted yield curve proved them wrong again.
"This time," the reason -- and there’s always some explanation why the spread means something different this time - - was the "global savings glut," which was directed to U.S. Treasuries and depressed long-term rates.
This time wasn’t different. And it has never been different for the past seven recessions, starting with the one in 1969-70. Yet every time the curve inverts, especially if the economy appears to be cruising along, economists refuse to believe the message, arguing, for example, that changes in the structure of the economy might change the relationship between the yield curve and economic activity.
Haven’t I seen the proliferation of weak economic indicators in the past few weeks? What about the debt crisis roiling Europe and central banks in emerging-market countries that are raising interest rates to curtail inflation? How about all the foreclosed homes that banks will eventually dump on an already depressed market? Commodities have rolled over, stock markets are shaky and the yield curve is nothing more than two points connected by a line.
Zero Benchmark Rate
Yes, I’ve seen or read all of the above. And I’ll still take the two points connected by a line over all the coincident readings on the economy’s health.
The Fed’s benchmark rate is at zero, providing a powerful incentive to arbitrage the yield curve, reach for higher returns and party until the central bank threatens to take the punch bowl away.
A $15 trillion economy doesn’t turn on a dime. Listening to the commentary, you’d think that one day inflation is ready to take off and the next the economy is struggling to stay afloat.
In the real world, things don’t change that quickly. The past seven expansions lasted 71 months, on average. The current one is not quite two years old. And by some metrics, it has yet to get going.
So if you think the U.S. economy is headed into recession in a matter of months, then I have some Greek debt to sell you.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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