From Our Briefings Newsletter
The difference in yield on longer- vs. shorter-dated Treasury bonds has flattened to razor-thin levels, fueling concerns that it could soon veer into negative territory. While this phenomenon—known as yield curve “inversion”—historically has predicted recession, its signaling power looks weaker this cycle in the eyes of Goldman Sachs’ Chief Economist Jan Hatzius and Chief Markets Economist Charlie Himmelberg. GS Research’s Marina Grushin sat down with the pair to discuss the relationship, including what signals to watch if not yield curve inversion.
The article below is from our BRIEFINGS newsletter of 16 July 2018:
Briefly . . . on Reading Recession Risk in the US Yield Curve
Marina Grushin: Let’s start off with the link between yield curve inversion and recession, historically speaking. Can you explain the dynamics at play?
Jan Hatzius: An inverted yield curve typically means the market expects large rate cuts from the Fed in the future. As for what fuels those expectations, it’s typically the perception that there’s economic weakness unfolding that will force the Fed to reverse previous hikes. And since the market looks forward and evaluates the evidence about how the economy is doing, very often that judgment turns out to be correct. So as a signaling device, the slope of the yield curve can be quite valuable—but it does not cause recessions, in our view.
Charlie Himmelberg: I’d generally agree. There is of course some causal transmission between tighter monetary policy and recession risk, and I think that can be reflected in the yield curve. The long end of the curve gives you some sense of where the average interest rate is expected to settle in the future. So the more inverted the curve, the tighter monetary policy is today relative to where the market expects it to be down the line.
MG: Jan, you’re not actually forecasting yield curve inversion. But how worried would you be if the curve did invert?
JH: We’re fairly close to inversion in our forecasts, with the 10-year yield only 25 basis points above the federal funds rate by the end of 2019. And there is a lot of uncertainty around this outlook, so it’s definitely possible that we get an inversion. However, I think the relationship between the yield curve and recession risk is likely to be somewhat weaker today than in the past. If you go back three or four decades, the extra compensation for holding a longer-dated bond, what’s called the term premium, was much higher than it is today. So an inverted yield curve would mean that the market was predicting a very large amount of rate cuts—and there was probably good reason for expecting such a drastic change. As a result, inversion was a very strong signal for a recession. But today, the term premium is depressed, so expectations of only 25 or 50 basis points of rate cuts could push the curve into inversion. And we consider that a less valuable signal of the economic outlook.
MG: Charlie, how are the markets thinking about this?
CH: The possibility of inversion attracts a lot of market attention. But I think we’ll have to discern whether the signal deserves as much weight as it’s gotten in the past. I agree that 50 basis points of inversion is probably not as negative of a signal today. So in the current environment, I think there’s a good argument to be made that we don’t have to be as nervous about inversion as we’ve been in the past.
MG: Jan, I’ll give you the last word--what do you think investors should be watching instead when they're thinking about recession risk?
JH: Overall, recession risk at the moment is quite low. I think what we need to watch is just how much more the labor market will overheat. If you do get a large overheating that ultimately translates into inflation well above the Fed’s target, then they probably will want to loosen the labor market. And that's proven difficult to do without generating a recession.