Saturday, April 21, 2018

Yield curve and growth - There is information here, but very early warning

There has been significant focus on the flattening of the yield curve, yet there has not been precision in what it is currently telling us. There has been extensive research on the predictive power of the yield curve and economic growth. A bibliography form the New York Fed lists over 90 research papers on the subject. The general theme is that an inverted yield curve is a good indicator of a recession and provides useful and independent research relative to other economic indicators.  However, we are not yet in inverted territory.

The Cleveland Fed does provide a level of precision on yield curve signals. These charts are as reported through the end of March and are likely to show more elevated levels, but the basic story is the same. Economic growth would be slowing and will likely be below 2%, but the probability of a recession is below 20%. Nevertheless, this probability is at the highest level since the Financial Crisis. The curve link with GDP suggests a one year lag relationship.

There is no doubt there should be heightened investor concern with this flattening, but a flattening is not an inversion and there is a risk from getting defensive too early. There is not a need to go to a risk-off portfolio, but there should be an awareness that further risk-taking would be at odds with developing evidence. 

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