[ Question ]

Do bond yield curve inversions really indicate there is likely to be a recession?

by bgold 1 min read10th Jul 20197 comments

22


I've seen some recent commentary that the bond yield curve indicates there is likely to be a recession in the next year.

For example, from the New York fed:
https://www.newyorkfed.org/…/r…/capital_markets/Prob_Rec.pdf

and commentary:

https://www.newyorkfed.org/medialibrary/media/research/capital_markets/Prob_Rec.pdf
https://www.wsj.com/…/government-bond-market-measure-says-r…

I'm not sure how much stock to put into this, or for that matter what actions I should take if I expected there would be a recession in the next year.

Two part question:

  • How much confidence should I have in the yield curve inversion signal that a recession would happen by July 1st, 2020?
  • If I expected there would be a recession, what actions make sense to take as a personal investor? Or even more generally?
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3 Answers

High short-term interest rates constitute relatively good evidence of a coming recession. The hard part is deciding what qualifies as high. "Higher than long-term rates" seems to get attention partly due to its ability to produce a clear threshold, rather than to anything optimal about the signal that's produced by long-term rates.

Note that if recessions were easy to predict, they would be easier to avoid than they have been.

A couple of thoughts.

One, the inversion seems to be in line with most credit cycle theories of economic activity I think. Basically, during an expansion debt increases and as the economy reaches it's peak you may see more reliance on shorter term debt for a number of reasons. When the short term debt costs rise that type of financing drives costs up, and so the marginal activities out of the market. Market activities are interdependent within an economy so you start seeing the domino effect play out.

The other thought I had was are we talking real economic activities, recession, or financial market activities (bear market/crash)? I think that matters if one wants to explore "what actions" anyone might consider taking. And, the answer will likely depend on the person's specific situation. Here it might be a bit like the distinction between recession and depressions -- recession if your neighbor looses the job, depression is you loose the job. How secure is your employment and income outlook is probably a more important question than if we have a recession in 2020.

I found this https://www.forbes.com/sites/johntobey/2019/05/31/yes-the-inverted-yield-curve-foreshadows-something-but-not-a-recession/#6b593af32800 and it might have some insights for you. I think the point that every case of inverted curves is not the same -- you need to understand the underlying drivers -- is particularly important to consider. As always, the devil will be in the details but everyone seems to want the simple heuristic. (I would think some Bayesian would be having fun here and maybe someone has info on that type of insight). I recall seeing something about duration of the inversion as well mattering but I seriously doubt one could say X days/weeks or less no recession but over that....

I think one can look at the curve inversion as one data element, not really a primary cause (my first comment aside) and put that in context with a number of other aspect. One, we've had a very long expansion -- but it's not be really exciting so perhaps it can run longer. We are in a presidential election cycle; they tent to be possible for aggregate economic activity. The geopolitical landscape is disturbing at best but it's not clear to me if that will be a positive or negative for any given domestic economy, USA or other. Inflation remains tame. Employment mostly okay (USA markets at least).

I think fears of recessions provide something of a wake up call to many. They worry and then look at what they have done in terms of savings and borrowing and it probably scares many. Rather than treating the situation as something of a new years resolution -- so soon forgotten once the new years passes -- consider making changes to behavior in the good times.



The popular saying is that bond yield inversions have predicted 6 of the last 3 recessions. In general, just run your same searches and append the word 'myth', 'misconception', 'doesn't' etc. If you use positive search methods the internet will tell you whatever you want.

More generally, market timers lose hard. Set your allocations such that you're comfortable with max drawdowns and plug money into it reliably. Recessions last on average 9 months and have an average draw down of 20%, not much to worry about in the long run.