The yield curve is one of the better recession indicators we have. The idea is that short rates reflect monetary policy (where the cash rate/Fed funds rate is/or-is-going-to over the very near term) and long rates reflect where the short rate is expected to go over time (specifically, what it will average) with some risk premia (term premia) thrown in.
So – short rates, entirely about the Fed, longer rates, still the Fed, but also the actions of bond market participants, and their expectations, and those expectations are pinned on the underlying expectations for growth and inflation.
As such, when long rates are below short rates (an inverted yield curve) the bond market expects the Fed to need to cut rates, which in turn it would be doing because it expects/is-responding-to a slow down in growth and inflation.
Hopefully, that is clear. Now in the US, the curve has inverted! Recession ahoy!
You can see the idea fairly clearly below – when short rates (2s, 3m) are at or above long rates (10s) a recession (grey bars) follow. But there is a complicating factor. Those risk premia that I mentioned (called term premia) cloud the signal.
If the causal factor of the recession was self-fulfilling expectations, than the non-expectations component shouldn’t matter so much.
In other words, we want to think about spreads excluding those premia. And they can be quite large, as you in the above graph (bottom section). Excluding them (the ACM estimates are popular, as are the KW estimates, we use both here) gives rise to a Term premia adjusted spread, which is still quite positive (the middle section of the above graph).
Popping that into a probit model, to calculate an implied probability of recession based on those spreads 12 months from now gives a wildly differing picture.
The inversion of the 2s10s suggests a 22% chance of recession, up from near zero 3 months ago. That’s a strong signal! But (as Fed Chair Powell would draw our eyes to) the 3m10s does not (at ~3%, i.e. very low) and that is the one he wants us to look at. The other term premia adjusted (e.g. x_TP_KW, x_TP_ACM) models suggest really no danger, and suggest that we (well, people worried about the inversion) are confusing movements in risk premia that are embedded in the yield curve with a collapse in expectations (which would signal danger).
Having read what I’ve written 3 times now, I fear it is a bit complex. But it is worth slogging through. If you just focused on the inversion on the standard measure, you might be ready to run for the hills. But inversions often take up to a year to play out negatively in both financial markets and the real economy, and the other indicators don’t give us a compelling reason to worry just yet.
Plenty of other things to worry about (commodity prices, war, valuations) but perhaps not this particular thing, just yet.
A more cynical interpretation might be that the market fears that the Fed will make a mistake (which the 2s10s suggest) by tightening too aggressively, but the good news is that it hasn’t made that mistake yet (which the 3m10s suggest).
Right. Back to it.
Please note that past performance is not a reliable indicator of future performance.