Does yield curve predict recession with precision? Answer is a Big No

The sudden inversion of the US yield curve (10Y-3Mo) on Friday to -3 bp, following the sustained decline in euro area manufacturing sector PMI to 47.3 in March 2019 has deepened fears of a recession in the US.

This contrasts with Fed Chair Jerome Powells assessment of “US economy in a good position” a few days back. The bond markets fears also contrast with other factors such as the generally robust stock market situation, with the S&P500 trading at 20-times trailing earnings, one-year break-even inflation rising to a 10-year high of 3.5 per cent (up from -3 per cent in Dec, nominal bond yield-inflation linked yield; source Bloomberg), and global crude prices rising 35 per cent from the lows of December 2018.

So, does the yield curve predict recession with precision? The short answer is a Big No.

First, the economic intuition behind the predictive capability of the curve. According to the permanent income hypothesis (Friedman), households current desired consumption is a function of both current income and foreseeable future incomes. Hence, if people are bullish about their future income, they will tend to spend more, possibly also by borrowing, i.e., saving less.

Hence, if collectively households desire to consume more and save less, there should be an upward pressure on real interest rates, implying a steepening of the yield curve. Conversely, if households are pessimistic about their future, the curve should flatten or get inverted. But flattening or inversion only tells us about a growth deceleration. What could make it turn into a recession are unexpected shocks.

Historical evidence shows curve flattening implies slower growth, but recessions are triggered by shocks.

The past four recessions were indeed preceded by flattening or inversion of the yield curve, which indicated a slowdown in consumption growth (1978-80, 1991-92, 1999-2000, 2007-08). However, flattening or inversion of the curve also occurred without leading into a recession in 1985-86, 1994-95, 1997-98 and 2005-06.

Thus, there are enough instances in the past where the curve flattening has not resulted in a recession. This implies that the curve inversion is not a good predictor of recession, although it makes the economy susceptible to one if there are external shocks.

For instance, the year 1981-82 had the Iranian Revolution in the backdrop, leading to an energy crisis (1979); the 1990 recession was triggered by the Iraq War which led to a spike in oil prices; the one in 2001 was due to the dotcom bust (asset price deflation); and the Great Depression (2007-09) also resulted from asset price bust (sub-prime crisis, stock market), impacting financial institutions.

So where is US economy now? It is in a good shape despite global headwinds.

The US economy is on a strong footing: job market conditions remain above normal, wage growth is good, and consumer confidence indicators are strong. Tax cuts and fiscal spending created positive demand conditions last year. Though it also implies slower growth in 2019, higher investments and labour force participation are expected to create a positive supply-side impact this year.

Financial market conditions are stable, banks are well capitalised, US households enjoy the highest-ever net worth/personal income of approximately 7 times, and households are not much leveraged. Despite the Feds rate normalization, interest cost/GDP at 3 per cent is still half of the level seen 10 years ago.

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