Is a recession imminent? The signal of the yield curves
According to the yield curve, there is about a one in two chance of the American economy going into recession in 12 to 18 months’ time. That probability is derived from a historical link: the yield curve has become inverted about one year prior to each of the nine recessions that the United States has experienced since 1955.
But can we really believe the yield curve? After all, while it has performed well in the past, we need to take account of the specific characteristics of the current economic environment and the various factors that influence the yield curve: a flattening of the yield curve does not necessarily imply a higher risk of recession. In the current context, for example, we need to consider that the risk of inflation is much lower now than it was in the mid-1970s; that reduces the need for protection against unexpected increases in inflation and therefore lowers the required nominal yield on bonds, especially long-term bonds. In addition, in recent times central banks have intervened on a massive scale on the financial markets via their asset purchase programmes, and that has further contributed to the decline in long-term interest rates. If we take account of these and other factors, the likelihood of a recession in the United States drops to around 10%.
There are thus sound reasons to think that the yield curve is no longer as reliable as it was in the past. Nevertheless, if we consider that the recession risk is negligible in the current environment, that implies that we believe that “this time is different” and perhaps that we are ignoring the reasons why the yield curve could have the power to predict recessions. Various reasons have been put forward in this respect. An inverted yield curve may point to a too tight monetary policy, or it may reflect a gloomy economic outlook. Finally, the yield curve could actually trigger a recession, for example if the financial markets saw it as a leading indicator of a future crisis.