Why an Inverted Yield Curve Won’t Signal the Next Recession

One of the most reliable indicators for the state of economic conditions in the U.S. over the past 75 years has been the shape of the Treasury yield curve.

Taking the difference between the yield of a longer term Treasury bond and the yield on a shorter term Treasury such as the 10 year (NYSEARCA:IEF) minus the 2 year (NYSEARCA:SHY) provides the current level of the yield curve.  With the 10 year currently around 2.6% and the 2 year at 0.4%, today the yield curve sits at 2.2%, near the upper end of its historical spectrum.  Other similar yield curve measurements use the 5 year minus the 3 month or some other combination of longer term rate (CHICAGOOPTIONS:^FVX) less a shorter term rate.

One of the primary goals of the yield curve is to get an idea of inflation expectations (NYSEARCA:SCHP) and risk in the lending markets.  During “normal” times the yield curve is positively sloped with the duration farther out in time yielding more than bonds with shorter durations.

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An abnormal, or inverted yield curve, occurs when longer term rates fall below short term rates.  This is typically caused by a falling long term yield as investors demand the safety of the longer term bonds driving their prices higher and rates down.

However, these precedents and historical structures all existed in a world pre-ZIRP (zero interest rate policies).

Historical Yield Curves

The first chart below shows the historical curve of the U.S.’s 10 year Treasury yield less the 3 month Treasury yield.  Since the 1950s an inverted curve (when the curve has fallen below zero) has occurred seven times, preceding seven of the last eight recessions with the lone non-signal (1960) also very close to zero.

Indeed an inverted yield curve has been a great predictor of slowing economic growth (GDP) as well as recessions and is something many investors are again watching as a sign for a slowdown.  But, I am afraid they will be looking for something that may never come.

Something changed in the 2000′s as the Fed adopted its zero interest rate policy “indefinitely”, keeping short term rates glued near zero percent.  In such an environment the only way to get an official yield curve inversion is for long term rates to fall below the shorter term rates now under 1%, something that would be unprecedented.

However, although unprecedented in the United States, this song has already been danced to elsewhere.

Japan’s Last Yield Curve Inversion Was in the Early 1990′s

The next chart shows Japan’s yield curve since the early 1970′s.  Notice how it has not dipped below zero since the early 1990′s even though on this chart there has been three recessions since?

In fact, Japan has seen numerous recessions although its yield curve never inverted as the short term rate has stayed below the 10 year rate displayed by the next chart.

This chart through 2014 shows 1998’s, 2001’s, 2004’s, 2008’s, and 2011’s recessions in Japan all occurred without an inverted yield curve, even though Japan’s former history also showed the yield curve to be a great recession predictor.

Instead, since the mid-1990′s a flattening of the curve as opposed to a full inversion was all the warning provided for an impending recession.

A History Lesson for the Fed

So, what happened in the mid-1990′s to make Japan’s yield curve inversion no longer a recession predictor?

The Bank of Japan started lowering discount rates toward zero in an effort to counter deflationary forces; sound familiar?

20 years later Japan maintains its short term discount rate below 1% and the Federal Reserve Bank of the United States also has now adopted a similar very low discount rate policy “indefinitely”.

The inverted yield curve may have worked well during times of inflation, but during times of deflation and low short term interest rates, its predictive power falls apart.  Instead investors should watch for just a flattening of the curve instead of an outright inversion as occurred in all the Japanese recessions since the mid-1990′s to warn of the U.S.’s next recession.

Given the extremely low interest and inflation rates, deflation remains the key risk to your investment portfolio as we outlined in our March Newsletter where we discussed one way to take advantage of deflation through the U.S. Dollar (NYSEARCA:UUP).  Its price is putting together a bullish long term chart pattern and should benefit as deflation continues.  We also discussed the implications a stronger dollar would have on commodities such as gold (NYSEARCA:GLD), which has already seen a 5% decline since due to U.S. dollar strength.

History teaches us that with such low interest rate policies, the U.S. is likely not to see an inverted yield curve again, but this does not mean recessions should not be expected as Japan has had five of them since adopting their version of ZIRP, dealing with deflation for over twenty years now.

The ETF Profit Strategy Newsletter analyzes the world’s markets to keep you ahead of major market trends.  Japan remains the best macro example for the U.S.’s monetary policy as their similar ZIRP policy has gotten rid of inverted yield curves, but not recessions or deflation.