Inverted yield curves - Is this time different? Perhaps not but look at the financial cycle for help

Market volatility has increased on the news that the Treasury yield curve inverted for 10/2-year yield spreads, albeit temporarily. We already have an inverted curve from the front-end so this further inversion was not really new news. It caused the inversion story to reach the headlines but has not changed the overall recession story, yet there have been some analysts that have argued that this time is different. There will always be contrarians, so it is important to look at other information that may support or reject a recession story.

The Bank of International Settlements (BIS) has published some interesting work on other financial factors that may have strong predictive power for a recession. Their research provides a direct comparison with the inversion story and suggests that the likelihood of any recession will be related to the financial cycle. 

The financial cycle according to the BIS "refers to the self-reinforcing interactions between perceptions of value and risk, risk-taking and financing constraints." The financial cycle does not match the business cycle and can last at least 15-20 years. The BIS researchers conclude that a financial cycle downturn is a better signal than an inverted yield curve and a combination may provide superior information. Inversion with a financial cycle turn is a strong recession signal combination.

The financial cycle story is one of credit excess. An increase in credit will inflate collateral prices which in turn leads to further increases the amount of credit that financial institutions will lend and borrowers will take-on. At some point the there will be an adjustment in collateral prices which will lead to a feedback loop of collapsing credit and further declines in collateral prices. The peak in the financial cycle will occur when there is a banking crisis or an increase in financial stress.  There may be a slowdown or recession with a yield curve inversion but the bigger and more meaningful signal is stress from extremes in the financial cycle. 

In the BIS Quarterly Review December 2018, the presentation "The Financial Cycle and Recession Risk" shows that a probability measure using a proxy for the financial cycle from BIS available data is a better recession indicator over both short and longer-term horizons. They find that a simple variable to use for financial cycle stress is the debt service ratio; see the BIS website for easy to read tables. Extremes in debt service provide the environment for a decline in the financial cycle which can predict a recession.

  
Debt service ratios for the private non-financial, household, and non-financial corporate sectors suggest that we may not be at an extreme. Some countries have reached highs but the US, while elevated are not at excessive levels. The power of lower interest rates has allowed creditors to handle higher debt levels. A similar story can be gleaned from the credit to GDP numbers. Trends suggest that credit levels are high, but not at extremes that place the financial cycle under stress. Now this can change if there is a shock to collateral, but yield curve inversions are noisy forecasts. Near-term concerns of recessions can be tempered; however, the feedback from costly high short-term rates on long bond investing and risky investing in general is real.