The yield curve’s unerring knack for predicting recessions seems to be a phenomenon exclusive to the U.S.
As the flattening of the yield curve brings it closer to an inversion, in which long-dated yields fall below short-dated yields, some investors worry that it could soon signal the end of the second longest U.S. economic expansion since World War II. But the phenomenon doesn’t travel well.
Quantitative analysts at AQR Capital Management found that the yield curve’s prophetic reputation was either nonexistent or weak in major economies from Australia to Germany.
“Internationally, the yield curve’s predictive power has been mixed,” said strategists for the world’s second largest hedge fund, in a note late last week.
The yield curve is a line on a graph plotting the difference between yields for debt of different maturities. Since investors typically demand a bigger premium to lend money over a longer period, the line usually curves upward.
The curve isn’t inverted, but it has been flattening, with the spread between 2-
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and 10-year note
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yields at 45.2 basis points, the tightest since 2007, Tradeweb data shows. According to the San Francisco Federal Reserve Bank, an inversion of the curve as measured by the gap between the 1-year
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and 10-year notes correctly signaled all nine recessions since 1955, with only one false positive. The delay between the inversion and the start of a recession ranged between 6 and 24 months.
Economists theorize the yield curve inversion is a harbinger of economic trouble for two usual reasons.
One, banks rely on short-term deposits to fund longer-term loans, harvesting the difference in interest rates. Because the net interest margin broadly correlates with the yield curve’s steepness, an inverted curve suggests banks would cut back on loan issuance, hurting business investment. Two, a yield curve inversion is a sign that monetary policy has become tight as a central bank’s hiking plans raises short-term yields much faster than the long-term yield, on which it has a weaker influence.
Investors might think these dynamics are universal and would play out in the same fashion in other countries.
But in Australia, the yield curve has inverted four times since 1990, but was only once followed by a recession. To be sure, weaker growth did follow the other three inversions.
The German yield curve’s predictive abilities came closest to matching that of the Treasury curve. Recessions followed after the German curve inverted in the mid-2000s and 2009.
But during the worst of the European debt crisis in 2012, which submerged Germany into a recession, the yield curve failed to undergo an inversion. The spread between 2-year
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and 10-year German yields
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has remained positive since the financial crisis.
Part of this newfound disconnect could be because Germany doesn’t have control of its own monetary policy. The European Central Bank controls interest rates for all eurozone economies.
Japan offered a clear-cut case in which the yield curve showed little value as an economic indicator.
The yield curve hasn’t inverted since 1991, yet Japan’s economy suffered from multiple recessions with the most recent one hitting in 2014 after the Japanese government raised the sales tax from 5% to 8%.
“It is possible to argue that the banking system in Japan is so broken that it doesn’t matter how steep the yield curve is, banks won’t lend anyway,” the AQR analysts said.
It isn’t just bank lending that has been in the doldrums. Muted trading activity in the domestic bond market can sometimes lead to days when a single benchmark 10-year Japanese government
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will not trade hands, according to Japan Bond Trading Co.
The AQR analysts say the real issue is likely to be the low interest rate policy following the Lost Decade in the 1990s, during which Japan suffered from a prolonged economic slump. Since then, the yield curve’s properties as a gauge of the tightness of financial conditions and monetary policy have broken down.
All of these examples, however, don’t take away the meaningfulness of the yield curve inversion in the U.S. After all, even as other major central banks have struggled to slough off their easy money policies, the Federal Reserve’s monetary policy is the closest to what market participants would describe as normal.
The Fed has already started to reduce its crisis-era balance sheet and has hiked rates six times since December 2015. As a result, U.S. bond yields are much higher than elsewhere.
“The yield curve remains a decent indicator of how tight monetary policy is in countries with active central banks in normal times,” the AQR analysts said.
See: Yield curve still has power to predict recessions, San Francisco Fed paper says
Source : MTV
