What Happens When the Yield Curve Inverts?

The yield curve for United States T-bills and government bonds inverted ever so slightly on December 19, 2005 (for the first time since the early months of 2000), and has stayed that way until the time of this writing. A normal yield curve is always upward sloping, since investors expect to be paid more for taking more risk as the term to maturity increases.

The curve looked like the one shown below on January 5, 2006, but check Bloomberg to see what it looks like right now, or have a look at this dynamic yield curve that matches interest rates to stocks over time.

Depending on the shape of the yield curve, a percentage probability of future recession can be inferred, as Arturo Estrella and Frederic S. Mishkin wrote in a 1996 Federal Reserve Bank of New York publication.

In his latest newsletter, John Mauldin helps to summarize the case for the yield curve as a predictive tool and describes what it means this time around:

Professor Campbell Harvey of Duke was the one that wrote about the relationship between recessions and the yield curve, and proved that the yield curve outperformed other forecasting tools in his 1986 dissertation at the University of Chicago. He published his dissertation in 1988 in the Journal of Financial Economics. In 1989, he published a follow up piece in the Financial Analysts Journal. Estrella (we'll read more about him later) and Hardouvelis picked up on the idea and published an article in 1989 and a few more.

Harvey's prediction about the usefulness of the yield curve was right on target. In 1991, after the 1990 recession he noted that inversions of the yield curve (short-term rates greater than long term rates) have preceded the last five US recessions, suggesting that the curve can accurately forecast the turning points of the business cycle.

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But [today's] level of spread has happened several times in the past 40 years and we have not had a recession follow. So why should we pay attention today?

Because for a full inverted yield curve to show up you will start seeing "signs" in the yield curve like we saw this week. These things start innocuously, usually when the economy seems to be booming, and most observers suggest we ignore them. And sometimes they are right.

But most observers suggested we ignore full-blown yield curve inversions as well. I think it was something like 50 out of 50 Blue Chip economists failed to predict the last recession even a few months out. They ignored the yield curve, all finding reasons why "this time it's different."

In a follow-on paper mentioned below, Estrella documents that each of the previous yield curve recessions since 1978 produced major academic papers telling us why this time it's different. They were all wrong.

This is certainly something to watch. In case you're curious, the yield curve for Canada also appears to sag in the middle: