The Yield Curve Is A Mis-Leading Indicator

Once again, the relatively flat yield curve has become the topic of a host of media and analysts’ reports.  A flat curve is thought to presage a recession and an attendant decline in bond yields.  That gives far too much credence to what has often been an unreliable indicator of future economic activity and bond market developments.

To argue that a flat curve has predictive power for the economy is to confuse correlation with causation.  In most previous cycles, by the time the curve had become flat or inverted, short-term rates and bond yields had risen to levels that were high enough to choke off economic activity.  In particular, the rise in mortgage rates was sufficient to produce a step decline in home construction, which has always had a significant multiplier effect on GDP.  It was the level of rates and yields that caused the recessions, not the configuration of the curve.

One could argue that in 2004-2006, bond yields stayed relatively low as short term rates increased some 400 basis points, and the consequent curve flattening correctly predicted a recession.  Even then, however, housing was the better leading indicator.  It was not apparent until much later the degree to which home purchases were being financed with ARMs that were priced off of short-term rates.  Thus, the rise in short rates caused a sharp contraction in housing activity, even though bond yields and rates on fixed rate mortgages did not rise much.  So, those looking for signs of a recession should probably watch the housing data, not the shape of the yield curve.

The same could be said to bond market participants.  The econ textbooks tell us that a flat curve means that the “market” is anticipating only small additional increases in bond yields.  The problem is that those market predictions are often wrong.  Those who have tested this hypothesis have found the curve to be a very unreliable predictor of the movement in bond yields.  For example, had one purchased long bonds when the curve inverted in late 1978, he would have lost almost half his investment by late 1981.

A better explanation for the current flattening is expressed in the latest Barron’s, quoting BMO strategists who cite exceptionally heavy Treasury issuance weighted toward the shorter maturities along with Fed rate increases as pressuring short term rates.  Another quote points out that the low level of rates and yields hardly suggest financial tightness.  That implies that it is still too early to begin buying long bonds.  The key question is always what levels of short rates and bond yields will slow business activity.  Unfortunately, if anyone knows, they are not sharing that insight.

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