The Predictive Power of Yield Curve Is Due to Its Link to The Economy’s Yield Curve

The minutes of the May 1 and 2 Federal Open Market Committee meeting noted “several participants thought that it would be important to continue to monitor the slope of the yield curve, emphasizing the historical regularity that an inverted yield curve has indicated an increased risk of recession”.

Policymakers concern about the yield curve may have been heightened by the Federal Reserve Bank of San Francisco (FRBSF) Economic Letter of March 5, 2018 which stated, “While the current environment is somewhat special---with low interest rates and risk premiums—the power of the term spread to predict economic slowdowns appears intact.”

The authors of the FRBSF article did not explain link between the yield curve and the economy only that its has been a very reliable and accurate indicator in foreshadowing future changes in the economy over the past 60 years.

Yet, as impressive as the record market yield curve has been so too has been the economy’s yield curve, or the spread between the growth in Nominal GDP (or income) and short-term interest rates. True to form, there has never been a recession in the postwar period without an inversion in the economy’s yield curve.

The accuracy of each yield curve raises the question of causality and the direct link to the economy. That’s especially important today since while the market yield curve is narrowing the economic yield curve is becoming steeper.

In a fundamental sense, nothing is triggered in the real economy when interest rates on short-term maturities are equal to or even exceed the yield on longer-dated maturities. To be sure, people don’t stop spending, jobs are not destroyed, income is not lost and firms don’t stop producing or investing. Some would argue that a narrow interest rate spread would signal tighter financial conditions and potentially less bank lending. But the truth of the matter is that bank lending rates are always markedly higher than Treasury borrowing costs so even with a flat or slightly inverted Treasury curve bank lending would still be profitable, although it is true that financial institutions could no longer profit from the interest rate spread.

On the other hand there are direct consequences to the real economy when short-term rates rise and match or overtake income growth. To be sure, when borrowing costs start to exceed the growth in income new borrowing starts to become too costly, and in time that slows the growth in new lending, consumer spending and eventually the economy. Also, to the extent that consumer finance costs are reset with changes in the federal funds rate the interest cost on past borrowings climb with a lag, resulting in higher interest expenses and less cash flow for spending. This process takes time to play out but one of the recurring themes of all economic cycles is that rising interest costs drains liquidity and cash flow, resulting in an economic slowdown or recession at some point.

The one shortcoming of the economy’s yield curve is that it is measured on a quarterly basis, whereas the market yield curve is shown daily. However, the introduction of GDPNow forecasting models by various Federal Reserve regional banks provides a running tally of current quarter growth trends, enabling analysts and policymakers to gain insight into economy’s underlying growth trends long before the actual release.

Based on available data, Q2 nominal GDP looks to be running conservatively 5.25% to 5.5% above year ago levels. Thus, even if the Federal Reserve raises official rates by 25 basis points, to 1.75 to 2%, as is widely expected at the June 12 and 13 Federal Open Market Committee meeting, the economy’s yield curve would be steeper (325 to 350 basis points) at mid-year versus the start of the year (290 basis points), sending a different signal on the economy’s future path compared to that of the market yield curve.

History has shown that the market yield curve and the economy’s yield curve have been joined at the hip (See attached chart). However, because of the changing nature and causes of business cycles, as well as the changing policy tools of the Federal Reserve, economic and financial relationships that were once viewed as sacrosanct do change and become less reliable; for example, the downgrade of M2 as a reliable indicator of financial conditions in the early 1990s.

It could well be the case that given the large-scale asset purchase program by the Federal Reserve the signal from the market yield curve has been altered. To be sure, given the large balance sheet of the Federal Reserve it could well mean that a sharply inverted market yield curve (100 basis points or so) would be equivalent to a flat market yield curve of pre-QE years. Consequently, a better and an unbiased signal would come from today’s economy’s yield curve.

At this time, it still appears that Fed is betting the market yield curve signal has not changed. I think the signal has changed; and my money is on the economy’s yield curve.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.