Flattening of the Yield Curve in Pictures; Is an Inversion Necessary to Signal a Recession?

Curve watchers Anonymous has an eye on the yield curve. Here is a snapshot of year-end-closing values from 1998-12-31 through 2015-12-31.

Yield Curve Year End Closing Values 1998-2015



Unlike 1999-2000 and again 2007-2007, no portions of the yield curve are inverted today (shorter-term rates higher than longer-term rates).

Inversion is the traditional harbinger of recessions, but with the low end of the curve still very close to zero despite the first Fed hike, inversions are unlikely.

Yield Curve Differentials: 3-Month to Longer Durations



Yield Curve Differentials: 1-year to Longer Durations



Yield Curve Differentials: 2-year to Longer Durations



In general, albeit with some volatility, the yield curve has been flattening and spreads shrinking since 2013.

If the economy was truly strengthening, one would expect the yield curve to steepen, with rates rising faster at the long end of the curve rather than the short end of the curve. But that's certainly not happening.

Is an Inversion Necessary to Signal a Recession?

Many believe no recession is on the horizon because the yield curve is not inverted.

Pater Tenbebrarum at the Acting Man blog dispels that myth in A Dangerous Misconception.

One popular theme gets reprinted in variations over and over again. Here is a recent example from Business Insider, which breathlessly informs us of the infallibility of the yield curve as a forecasting tool: “This Market Measure Has A Perfect Track Record For Predicting US Recessions” the headline informs us – and we dimly remember having seen variants of this article on the same site at least three times by now:

There are very few market indicators that can predict recessions without sending out false positives. The yield curve is one of them. At a breakfast earlier today, LPL Financial's Jeffrey Kleintop noted that the yield curve inverted just prior to every U.S. recession in the past 50 years. "That is seven out of seven times — a perfect forecasting track record," he reiterated.

This is it! The holy grail of forecasting, Jeffrey Kleintop has discovered it. You'll never have to worry about actual earnings reports, a massive bubble in junk debt, the sluggishness of the economy, new record levels in sentiment measures and margin debt, record low mutual fund cash reserves, the pace of money supply growth, or anything else again. Just watch the yield curve!

When Perfect Indicators Fail

The so-called “perfect track record” Mr. Kleintop emphasizes is pretty much worthless once the central bank enforces ZIRP on the short end and has already begun implementing massive debt monetization programs. Here is a chart showing the relationship between 3-month and 10 year Japanese interest rates since 1989, with all six recessions since then indicated:



Over the past 25 years, the “perfect forecasting record” has worked exactly 1 out of 6 times in Japan – and that was in 1989.

There is no “holy grail” indicator that can be used to make perfect economic and market forecasts. It is true that if there is a yield curve inversion, it definitely indicates trouble is on the horizon. Alas, we don't remember hearing many real time warnings (in fact, we don't remember any) from Wall Street analysts when such inversions actually occurred in the past (such as e.g. in 1999/2000 and 2006/2007), which makes this new preoccupation especially funny. Obviously, the only time to pay attention to this indicator is when it suggests that a bubble can keep growing!

There is only one thing that is certain: things will continually change. There is no indicator that is fool-proof.

I captured the charts at the beginning of this post on December 31. With the 2016 opening equity carnage today, the curve will be flatter at the end of the day.

The yield curve does not believe the economy is strengthening, and neither do I.

Mike "Mish" Shedlock