Recession Watch: A Crucial Yield Curve Concept

I want to highlight an insight that is crucial to those looking at the yield curve as a recession indicator.  (Others look at a slowdown or crash or whatever in housing, a subject for a future post.  One thing at a time).

Rob Martorana is the Director of Content (aka bandleader) for’s professional products.  He both provides frequent commentary and also stimulates participants to provide their views on key concepts.  Whether you agree or disagree with the authors there, it is always a stimulating source for hedge fund managers and active traders.

Today Rob asked contributors to write about the yield curve and recession chances.  There was a lively discussion. We will look under the tent flap, highlighting yet another important comment by Scott Rothbort.  This is something that readers are unlikely to have seen from other sources, so it deserves special attention.  It is one of the most insightful comments I have seen in years of reading the site.


First, a little background.  At "A Dash" we have reviewed a lot of the yield curve studies and tried to de-mystify this subject for non-economists.  It is widely misunderstood.  Before taking a major market position based upon the inverted yield curve, we urge readers to review the background.

We have pointed out, among other things, the following:

  1. An inverted yield curve is a potential indicator of recession, not a cause.
  2. Modern studies base conclusions not only upon the shape of the yield curve but also the overall level of interest rates.  An inverted curve at low rates is not as bad as one at high rates.
  3. It is important to understand causation.  Why does this indicator work?

Historically, there is a relationship between inflation and unemployment, a proxy for economic growth.  Many years ago this was called the Phillips Curve.  For a variety of reasons, this term fell into disfavor.  Many economists, including those on the Fed staff, now talk about NAIRU, the non-accelerating rate of unemployment.  Both concepts suggest that there is a natural limit to economic growth.  If growth gets too great, the market recognizes that restriction is required, predicts a slowdown, and that leads to lower long-term rates.

That is an extremely brief description of why the yield curve indicator has worked in the past.  But we want to know how it will work in the future, and particularly, will it predict correctly right now!

The Application

With that background, here is part of Scott Rothbort’s ten-point analysis of the current situation:

4. The yield curve does not worry me. The FOMC controls the
short end of the curve; the marketplace controls the longer end. Now more than
ever, the more expansive holding of U.S. dollars by foreign central banks is
creating increasing demand on the longer maturity U.S. Government debt
instruments. Thus, the yield curve is flattening out and to some extent
inverting. The shape of the yield curve will no longer only be reflective of
perceived economic conditions but will also include the impact of central banks
on the U.S. dollar and their appetite for Treasury securities. While I hate to
use the term "new paradigm" and will not, I will say that we are
going from a single variable yield curve to a multivariable model. We need to
understand and respect that.

5. Globalization of free trade and capital deployment added together
with more experienced central banks around the world create a global economic
diversification, which minimizes economic risks while maximizing economic

You may need to read those paragraphs twice, but it will be time well spent.  We are in a world where we have created a lot of free trade, expansion of developing economies, and the need for foreign central bank reserves.  These banks view gold and U.S. Treasury obligations as equivalent reserve holdings.  As their economies grow, so does their need for reserves.  Scott is using his expertise in resesarch methods to explore the causal models used in yield curve analysis.  At "A Dash" we look for the best contributions of experts in each field, so we think his analysis deserves respect.  (We invite you to compare any of the yield curve analyses you see almost every day.  Note the absence of reasoning or thought about what is behind this indicator).

We might add that there are also many bond traders who seem to have confidence in the Fed’s commitment to control inflation.  The long end of the curve is not under direct Fed control, but it does act as a monitor of long-range inflation expectations (as does the TIPS spread, confirming these low forecasts.)

Is this build-up of foreign reserves problematic for the U.S.  Will there be a sudden "run on the bank?"  Here is part of an email that I sent to an old colleague, an economics professor, eighteen months ago, before I was writing this blog.  He had sent me a commentary from someone raising questions about debt levels in foreign hands and using the typical scare rhetoric.  I wrote as follows:

    Given the desires of foreign governments (employment, building industry, etc), and given GATT and NAFTA and
WTO (which you and I both aggressively supported, I think), isn't the current
account deficit an inevitable consequence? If we want globalization, we can't
fix this on our own, especially if they keep buying securities.

The "loan shark at the door" rhetoric harkens back to the
isolationism of a century ago and also Post WWI. Free trade and globalization
are supposed to align the interests of countries. I have trouble visualizing a
scenario where East Asian banks would all want to dump U.S. Treasuries. They
would be the first to suffer in the short run, and then again in the long run.
If they change policy, it will have a gradual quality. Rates will rise. Other
sources of lending will emerge. Isn't that what you would teach in a class?

The Conclusion

At "A Dash" we are not saying that there cannot be a recession.  The "normal" historical expectation of a recession within one year is about 20%, a fact that blissfully eludes most commentators.  This is normal history because there are always chances for some economic shock.  When the economy is on the Glide Path of about 3% real growth, an unexpected event can lead to a recession.  Most economists put recession odds slightly above the historic norm because of the Fed’s tightening cycle.  Those who take a superficial view of the yield curve (and ignore the recent studies) put the odds much higher.

But what if Scott is right?  The chances of a recession would then be much lower!  The economically sensitive stocks that have been punished since mid-May are the real contrarian plays.  Tech, energy, and financials would also deserve a long look.

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  • Nima Mahdjour May 31, 2007  

    I have a question:
    Why are you saying that the FOMC does not control the long end of the curve?
    The Federal Reserve’s balance sheet ( shows that about $229 billion are held in Treasury securities that are due within the next 1-5 years and a significant amount of $156 billion are invested in securities that fall due within the next 5- over 10 years.
    Based on this I draw the conclusion that the FED has a significant control over the whole spectrum of the curve.
    I would like to know why you think it does not.
    Kind regards,

  • Jeff Miller May 31, 2007  

    Thanks for your question, Nima.
    The Treasury and the Fed operate independently and with different missions. The Treasury has to fund government spending, so their effect is limited to choosing duration of the issued debt. You are correct in saying that this has an effect, but it is not something under the Fed’s control.
    Fed decisions impact longer-term debt through inflation expectations, and perhaps through expectations for future short-term interest rate changes.
    Their influence is therefore indirect.
    Thanks again,

  • Nima Mahdjour October 3, 2007  

    Hi Jeff,
    thanks for the reply. But I feel like my main point is still unanswered. In your post you were saying that the FED’s policy does not have a direct impact on the long term interest rates for treasury bonds (the long end of the yield curve). But if the federal reserve has printed money and used that money to purchase $156 billion in long term treasury bonds, this activity must have exercised an upward pressure on the price for each one of those bond contracts and hence lowered the interest rate for them. To be more precise, per additional bond contract purchased by the FOMC, the interest rate for the next available bidder must have dropped below a level that it would have been at, had the FOMC not made the purchase.
    The decision to buy those bonds must have been made by the FOMC, so why should it be out of its control?
    Thanks in advance,