Fed Admits 'Yield Curve Collapse Matters'

As the US Treasury yield curve collapsed over the last year, various Fed speakers have promulgated the "it's probably nothing" or "it's different this time" narrative to divert attention away from the curve's almost-perfect record of predicting US economic recessions.

Even US Macro data has started to disappoint (and stocks briefly caught down to it)...

So, it is fascinating that none other than Janet Yellen's old haunt - The San Francisco Fed - has issued a report warning about the flattening of the yield curve...

"[it] is a strikingly accurate predictor of future economic activity.

Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve.

Furthermore, a negative term spread was always followed by an economic slowdown and, except for one time, by a recession."

Furthermore, as the two Fed authors explain below, the recent decline in the Treasury curve is sending recession probabilities notably higher...

The predictive power of the term spread is immediately evident from Figure 1, which shows the term spread calculated as the difference between ten-year and one-year Treasury yields from January 1955 to February 2018, together with shaded areas for officially designated recessions.

Every recession over this period was preceded by an inversion of the yield curve, that is, an episode with a negative term spread. A simple rule of thumb that predicts a recession within two years when the term spread is negative has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession. The delay between the term spread turning negative and the beginning of a recession has ranged between 6 and 24 months.


The central feature of the business cycle is that expansions are at some point followed by recessions. Long-term rates reflect expectations of future economic conditions and, while they move up with short-term rates during the early part of an expansion, they tend to stop doing so once investors’ economic outlook becomes increasingly pessimistic. A flatter yield curve also makes it less profitable for banks to borrow short term and lend long term, which may dampen loan supply and tighten credit conditions. .


The key question is which threshold to choose; in other words, how far does the term spread need to decline so that a forecaster should predict a future recession? Analyzing the number of false positives and false negatives for each possible threshold suggests that the best trade-off is accomplished for a threshold very close to zero. There appears to be something special about a negative term spread and yield curve inversions, both for predicting recessions and, according to additional analysis, for predicting output growth.

The implication is that a negative term spread is much more worrisome for the economic outlook than a low but positive term spread.


A number of observers have suggested that a low or even negative term spread may be less of a reason to worry than usual, arguing that historical experiences do not necessarily apply to the current situation; but Michael Bauer and Thomas Mertens also add that "it's not different this time"...

"While the current environment is somewhat special - with low interest rates and risk premiums - the power of the term spread to predict economic slowdowns appears intact".

An extensive analysis of various models leads us to conclude that the term spread is by far the most reliable predictor of recessions, and its predictive power is largely unaffected by including additional variables.

Bauer and Mertens conclude by crushing The Fed's narrative:

Forecasting future economic developments is a tricky business, but the term spread has a strikingly accurate record for forecasting recessions.

Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession. While the current environment appears unique compared with recent economic history, statistical evidence suggests that the signal in the term spread is not diminished.

These findings indicate concerns about the scenario of an inverting yield curve.

Any forecasts that include such a scenario as the most likely outcome carry the risk that an economic slowdown might follow soon thereafter.

So who do you believe? The Fed's researchers or The Fed's talking heads?

Read the full paper here...


taketheredpill Mon, 03/12/2018 - 14:46 Permalink

"Long-term rates reflect expectations of future economic conditions and, while they move up with short-term rates during the early part of an expansion, they tend to stop doing so once investors’ economic outlook becomes increasingly pessimistic."


Like just after the FIRST rate hike in 2015?


Iconoclast421 Mon, 03/12/2018 - 14:50 Permalink

They will just print more money to buy up the short end to keep the yield lower than that of the long end. Not hard at all to do, especially with the help of their Swiss and Japanese buddies.

ted41776 Mon, 03/12/2018 - 14:56 Permalink

fuck the fed. they are neither "federal" nor do they "reserve" anything. all they do is continuously devalue the fiat i receive in exchange for not spending time with my family and not doing things that i enjoy. they are devaluing my time and my life. this is not political, it is as personal as it gets. fuck them and fuck them some more after that

Roger Ramjet Mon, 03/12/2018 - 15:08 Permalink

Everything needs to be rebooted from time to time.  It would probably be very useful for all Central Banks to take a step back and allow the market to set rates, both long and short, just to see how far off base their current monetary prescriptions have taken things.  It would probably be very enlightening and ultimately beneficial for everyone concerned.  Under such conditions, Central Banks may actually be able to make some sensible decisions.

itstippy Mon, 03/12/2018 - 15:24 Permalink

Tight yield spreads in Treasuries are typical of fragile recoveries like this one and prolonged robust economic expansions like this one.


buzzsaw99 Mon, 03/12/2018 - 16:48 Permalink

recessions preceded by an artificial  negative term spread caused by the fed itself.  you'll notice they never ever take credit for the shit that they themselves cause.  there is nothing organic about it.  the spread collapses because they jack the front end after blowing an enormous bubble and the long end is where people hide out.  it's sickening watching them talk like they are just innocent observers.

khakuda Mon, 03/12/2018 - 19:37 Permalink

There is one major difference today.  In the past, other than the short end which was Central Bank set, rates across the curve were set by the markets.  Today, you have CBs globally printing money and buying medium and longer term debt as well, including foreign debt at HUGE levels.

Prices are set by the marginal buyer.  CBs are not only the marginal buyer, they are buying on margin with unlimited fire power, so good luck gleaning any information or making any predictions off of yield curves.

It is all bullshit at this point.