Inverted Yield Curves and Recession Caution

The inversion of the yield curve has always been a good sign of a potential recession. It has been argued by many as one of the best indictors of a coming recession relative to any other set of macroeconomic variables.

The curve continues to stay inverted, but there has not been the expected recession only the “happy slowdown”. However, it should be noted that the yield curve currently has an unusual shape. While the front-end is inverted, there is a corresponding dip in yields to make the longer end slightly positive. This shape may cause a dampened signal.

A knee-jerk reaction to any inversion may be misplaced given the dramatic changes in financial markets. Also, the lag relationship between inversions and the actual recession has been highly variable; nevertheless, there are growing signs of a slowdown in the US economy.

The best work describing the research on yield curve inversions can be found through the question and answers presented by economists from the Fed of New York. (See http://www.newyorkfed.org/research/capital_markets/ycfaq.htmlwyorkfed.org/research/capital_markets/ycfaq.html.) The use of the yield curve as a signal may have deteriorated in the last 20 years and there have some lapses in the signal, notably recessions which were not signaled; nevertheless, all recessions have been preceded by inversions.

Financial innovations may have muted the relationship between the curve and economic growth. Two transmission mechanisms which have changed may cause the quality of inversion signal to change in sensitivity and timing.

Corporate America and financing. The financing of corporations and banking in America is more global. From a banking perspective, funds can be sourced from all over the world so it is not as relevant that the US curve is inverted as much as if global yield curves are inverted. Financing can occur through carry trades from any country which has rates below the United States. The key for a global slowdown is if there is global inversion, a change in the risk profile of the balance of payments surplus countries who are supplying funds, or if there are restrictions on the flow of capital across borders.

In the case of corporate America, funding can be also conducted on a global basis, but the real issue is whether funds are needed. At this point in the business cycle corporate America is still showing signs of good earnings growth. In fact, there is still a net positive buyback of stocks which suggests that a corporation do not have a need to retain or borrow funds for projects which will change stock valuations.

The FDIC has presented very good evidence on the impact of inversion on the net interest margin of banks and suggests that it is not as sensitive as previously to the shape of the curve. Net interest margin has also converged across banks and large banks are increasing their sources of non-interest income. Large banks have always been more sensitive to the wholesale fund market, but they have diversified their income stream. Fewer profit constraints means there are no problems with supplying credit. http://www.fdic.gov/bank/analytical/fyi/2006/022206fyi.html

Consumer America is more sensitive to short rates. While corporations and banks may not be as constrained by an inversion of the yield curve, the same cannot be said for consumers. There has been a significant change in the borrowing practices of consumers through the extensive use of adjustable rate mortgages which were not as actively used during the last major inversion of 2001 and certainly not in 1989. Historically, the transmission of inversions was through disintermediation of credit from banks. Inversion with Reg. Q caused the supply of credit to decline. Now the supply is not the problem as much as the cost of the credit. (This, however, may change if there is a change in credit standards from the subprime problem.) Because the price of credit and not the availability is the constraint on consumers, the sensitivity of the economy to an inversion may be less and take longer. Certainly this will be the case for new loans. With more adjustable rate mortgages, there also will be more sensitivity to rate changes and inversion for existing loans which will be repriced. The impact of repricing will be based on the rate caps and the timing of the loan origination. Nevertheless, the rapid increase in rates with an inversion will cause more borrowers to be forced out on the curve at less acceptable rates.

The inverted yield sign is still the best signal for a recession; however, the time delay may be longer. The key will be the consumer transmission mechanism through the mortgage markets.