An age-old debate is bubbling up again about the value of a bond-market gauge that’s sending warning signs about the U.S. economy, mirroring a discussion that took place before the last recession.
The so-called yield curve, which can be measured by looking at the differential between two-year and 10-year Treasury yields, has been shrinking in recent months, falling to as little as 0.52 percentage point last week. That about half its level from May.
Long-term yields tend to go up and down alongside expectations for growth and inflation, while short-term yields tend to rise when the Federal Reserve raises rates. A low long-term yield, especially at a time of rising short-term rates, is thought to be a sign of caution. And when long-term yields dip below their short-term counterparts in what’s known as an inverted yield curve, it has reliably indicated a coming recession.
While the yield curve isn’t inverted at the moment, the accelerated
of flattening recently has unnerved some economists and investors. It’s also emboldened others who say the yield curve’s forecasting power is being obscured by a unique set of factors, including the growing participation of foreign buyers and declining demand for additional compensation to own longer-term debt.
“There is a strong correlation historically between yield curve inversions and recessions,” said Fed Chairwoman Janet Yellen at a press conference Wednesday. “But let me emphasize that correlation is not causation, and I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed.”
Compare that to what happened the last time the yield curve sent an ominous signal about a recession in the mid 2000s.
The flattening of the curve, which began in mid-2003, picked up steam a year later as the Federal Reserve started a steady drumbeat of rate increases. Short-term Treasury yields rose along with the central bank’s key policy rate, while long-term rates confounded economists by resisting a move higher. Alan Greenspan, then the Fed chairman, called that development a “conundrum
” in early 2005.
The yield curve debate continued to intensify throughout that year as it flattened more. With few economic worries on the horizon, many were ready to write off the value of the yield curve as a predictor — including Mr. Greenspan. A Wall Street Journal article from Dec. 2005 laid out the arguments:
“A growing chorus, including Federal Reserve Chairman Alan Greenspan, is challenging the reliability of the yield curve’s forecasting ability. Heavy foreign buying of U.S. bonds drives prices up and keeps long-term yields, which move in the opposite direction of a bond’s price, low. The heavy foreign buying, the argument goes, keeps long-term yields unusually low, which could help the economy, even as short-term rates rise.
“Skeptics say such arguments are reminiscent of the talk of the indestructible New Economy that helped drive the dot-com bubble in the late 1990s.”
A few weeks after that article published, two-year yields popped slightly above 10-year yields, the first instance of the yield curve inversion during that period. A Journal article from Dec. 29 of that year quoted economists continuing to shrug it off. As one put it: “I think the bond market is on drugs… It’s hard to take the yield curve seriously as a recession indicator.”
In February 2006, Ben Bernanke took over as Fed chair from Mr. Greenspan. A month later, in a speech at the Economic Club of New York, Mr. Bernanke gave a speech titled “Reflections on the Yield Curve and Monetary Policy
.” He said:
“Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates–in nominal and real terms–are relatively low by historical standards. Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative.”
The yield curve stayed negative for most of 2006, even after the Fed stopped lifting rates in the middle of the year. In 2007, as signs of economic weakness cropped up, the Fed started lowering rates, pushing the spread between the two-year and 10-year yields back into positive territory. But a nasty recession was already approaching that would take a heavy toll on the economy.
It’s tough to tell what a flattening yield curve is signaling this time around — particularly because it hasn’t yet inverted. Plus, the decade-ago experience shows that a recession can lag years behind
a yield curve inversion once it does happen. But some say the lesson from the last time around is clear: keep an eye on the yield curve, and take the words of economists–even Fed chairs–with a grain of salt.