Inverted yield curve is a very powerful predictor for upcoming recession. I still remember vividly back in 2006, the yield curve was inverted, but the economy looked bright and robust. Alan Greenspan thought "this time is different", and hypothesized that the yield curves was inverted because of global savings glut, with Asian central bankers heavily buying US long-term treasuries – this phenomenon is the so called "Greenspan Conundrum". But eventually recession hit us in December 2007, and still we are not completely out of it.
So what the current yield curve tells us about the economy – analysis from WSJ:
There's no surefire way to forecast recessions. But watching the "yield curve" comes awfully close.
Essentially the difference between long term and short term U.S. government debt yields, the yield curve is a powerful harbinger of recessions and recoveries. Nearly every time the yield on short-term debt has surpassed the yield on long-term debt—what's known on Wall Street as an "inversion"—a recession has followed.
Meanwhile, a "steep" yield curve, when long-term rates are much higher than short-term ones, usually augurs strong economic growth. Back in February, the difference in yields on the 10-year and two-year Treasury notes hit 2.929 percentage points—a record high. That also helped fuel the V-shaped rebound in the Conference Board's index of leading economic indicators. Little wonder investors felt good about recovery prospects at the time.
The yield curve has since flattened, but at about 2.16 percentage points it remains pretty steep by historical standards. That is a key reason why many economists still see a fairly small chance of a "double dip."
Yet some caution that the yield curve is distorted at the moment by the Federal Reserve's unusual degree of interference in the Treasury market. For example, by holding short-term rates near zero, the Fed has all but ruled out the possibility of an inversion. The yield curve "may not presently be an accurate signal," San Francisco Fed researchers said in a recent paper. Excluded from calculation of the Conference Board's index, they found, "generates far more pessimistic forecasts," which puts the odds of recession during the next two years above 50-50.
So if July's index of leading indicators, which includes the yield curve, posts a small gain as expected when the figures are released Thursday, investor reaction may be understandably muted. But they shouldn't ignore the yield curve altogether. After all, when the curve inverted back during the boom in late 2005, there were similar dismissals of its predictive power. At the time, it was said to be distorted by large-scale foreign purchases of U.S. government debt. Yet by December 2007, the economy was in recession.
What message then is in the yield curve fortune cookie? For now, it seems to be: dimmer recovery, but not quite lights out.
update 1. Yield curve dynamics
Watch this fantastic movie clip on how yield curve (to be more precise, the term structure of interest rates) evolved during the past few years. (ht: Jim Hamilton).