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The Inverted Yield Curve - 2/1/06

The Inverted Yield Curve - 2/1/06

The financial press seems very concerned with the "inversion of the yield curve."  So what are the issues and is the concern valid?  The inverted yield curve is the subject of this week's Investor's Insight.

First, the yield curve is a plot of the yield on bonds with the same credit quality across different maturities (the link above provides an interesting interactive model of the "living" yield curve).  The basic assumption is you get more interest on your investment in a bond by holding it longer.  The theory states there is more risk for holding a bond for 10 years than for 5 years, or for 5 years than for 90 days.  Bloomberg provides an current chart of the yield curve for U.S. Treasuries at  Bloomberg.  The chart below is from the Bloomberg site as of the end of business February 1, 2006.

Most of the time the curve or graph will start in the lower left and rise to the upper right.  Today it sags in the middle, which means that yields on the 2 year note is paying more than the 5 year bond.   This is an inverted yield curve.  In the past the entire yield curve goes from the upper left to then lower right on the graph. When this happens the yield curve is said to be fully inverted.  How far the yield curve inverts gives us a percentage probability of the likelihood of a recession within 3-5 quarters. So, we pay attention to this curve.  Note that the yield on the 3 month treasuries is lower than the 10 year bond.  The importance of this is discussed below.

Professor Campbell Harvey of Duke wrote about the relationship between recessions and the yield curve, proving that the yield curve outperformed other forecasting tools in his 1986 dissertation at the University of Chicago that was published in the Journal of Financial Economics in 1988.  I recommend Professor Harvey's website as a great source for financial and economic information. 
http://www.duke.edu/~charvey/

In 1996, economists for the New York Federal Reserve Bank, Arturo Estrella and Frederic S. Mishkin, published an article in the "Current Issues in Economics and Finance" published by the New York Federal Reserve Bank.  They compared the value of the yield curve as a prediction tool to three other possible indicators, including the so called "leading economic indicators" from the Conference Board. The only reliable predictor four quarters out was the yield curve spread. More specifically, they found that the "the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill--is a valuable forecasting tool."  This paper is available at  http://www.newyorkfed.org/research/current_issues/ci2-7.pdf.

In that paper they used the 90 day average of the spread between the 90 day T-bill and the ten year bond, since there are several times where the yield curve inverted for a few days but did not stay that way for long. In these cases recessions did not follow.

Estrella and Mishkin developed a probability table about how likely a recession would be 4 quarters later given a particular level of the yield curve spread.  The spread in the table is the 90 day average.  Basically, if the spread is 0.46 basis points, there is a 15% probability of a recession four quarters later.  And that is roughly where we are today. 

 

But that level of spread has happened several times in the past 40 years and we have not had a recession. So why should we pay attention today?  Well, for a full inverted yield curve to take place we will see indications in the yield curve like we are seeing now.  Keep in mind this starts innocently and with the economy doing well it is hard to pay attention to the sign posts.

Today, February 2, 2006 the Fed funds rate is at 4.5% and it is likely it will go to 4.75% at the next Fed meeting on March 28th.  The 10 year is now at 4.38%, so if does not move up, we need to pay attention as it would be a sign of a fully inverted yield curve. 

So if the yield curve fully inverts, does that mean we will have a recession in 2006?  Not necessarily, since to get a 90 day average negative number is going to take close to 90 days. That puts us at the end of the 1st quarter 2006, assuming the start of the inverted yield curve began the beginning of this year.  We still have 3-5 (4 quarters is the average) quarters before a recession will be in place.

So what do we do now.  Well, we need to monitor the yield curve over the next quarter.  If we see a full inversion then a slowdown is likely later in 2006.  Transitioning to a recession from a strong economy takes time.

According to various studies, the stock markets fall 40-50% before and during a recession.  Keep in mind that the stock market is a leading indicator so it usually moves down before a full recession is in place.  As an investor and trader, you do not want to wait until then to get out of your long positions.  In fact, by the time we are in a recession it is usually a good time to establish new long positions.

So for now we need to monitor the yield curve.  The next sign post ahead should the be the January 31st Fed meeting.  We will keep you posted.

  

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