Key Points:
- The predictive power of the yield curve is often overstated, as the causal correlation between long and short rates is weak.
- The history of the yield curve shows that long and short rates move in the same direction but at varying rates.
- The Federal Reserve’s influence on long and short rates has evolved over time, leading to a divergence in how the market sets these rates.
- Prior to the 1930s, positive yield curves were irregular, while the integration of Keynesian economic policies shifted the slope of the curve.
- The combination of Keynesian policies and the market’s discounting mechanism made the yield curve the predictive tool it is today.
- The yield curve inversion alone is not an accurate indicator of a forthcoming recession; extended periods of divergence between the market and the Fed are required for recession expectations to play out.
The predictive power of the yield curve is a widely accepted narrative, but the reality is that the correlation between long and short rates is not as strong as commonly believed. While long and short rates generally move in the same direction, the speed of their movement varies.
The establishment of the Federal Reserve System in 1914 and the subsequent adoption of modern central bank practices during the Great Inflation of the late 1960s to early 1980s contributed to a divergence in how long and short rates are determined. The accuracy of the yield curve as a predictor was mixed in the first half of the 20th century but became more reliable in the second half, coinciding with changes in the Federal Reserve’s approach.
Historically, yields for short-term commercial paper were higher on average than those of long-term bonds in the 19th century and the early 20th century. As interest rates experienced a downward trend due to peace and deflation after the US Civil War, the market set interest rates based on the supply and demand of loanable funds. However, the low interest rates during this period did not prevent numerous recessions.
Higher interest rates between 1900 and 1920 also did not have a significant impact on the economy, with several recessions occurring during this period. A persistently inverted yield curve may have contributed to the frequent recessions as it discouraged long-term investment.
The 1930s marked a shift towards positive yield curves becoming more regular. The stock market crash of 1929, increased state economic planning, and the integration of Keynesian economic policies all played a role in altering the slope of the yield curve. With short rates gaining attention from economic policymakers, a new causal force emerged that disrupted the relationship between short and long rates.
As the market became responsible for setting long-term rates, a disconnect between the views of policymakers and the market on the state of the economy emerged. The Federal Reserve’s open market operations, which are countercyclical, lag behind real economic conditions. In contrast, the market, representing the collective wisdom of the crowd, is forward-looking. When the market perceives the Fed as too hawkish, long rates fall below short rates. Conversely, when the market considers the Fed too dovish, long rates rise above short rates.
Market prices serve as the best indicator of future market outcomes due to the potential rewards they offer. If the future can be predicted in any way, free market prices are the most effective crystal ball because resources will be directed towards taking advantage of any mispricings. However, financiers in earlier eras did not recognize a connection between long-term and short-term rates, perceiving short-term lending as focusing on the return of principal and long-term lending on the return on principal. The combination of Keynesian economic policies and the market’s discounting mechanism eventually transformed the yield curve into the predictive tool it is today.
Nonetheless, caution must be exercised when utilizing the yield curve as an indicator. It is not solely the slope of the curve that matters; how it develops and the duration of any inversion also play crucial roles.
Cumulative Days of Yield Curve Inversion
Source: Federal Reserve Bank of St. Louis, NBER
The yield curve has inverted 76 times from positive to negative since February 1977, ranging from periods lasting months to just a day. However, there have only been six recessions during this time, indicating that inversion alone is not a reliable indicator. Extended periods where the market expects significantly lower growth than the Federal Reserve tend to lead to actual recession outcomes. Given the efficiency of the market voting machine, this outcome should not come as a surprise.
While the yield curve is a popular indicator for predicting recessions, further evidence of its efficacy, especially in situations where it suggests that Federal Reserve policy is too loose, is needed.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images/ ardasavasciogullari
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can easily record credits using their online PL tracker.
