Some Strong Support for Barry from Studies

There is very strong support for the yield curve association, and I’ll link to some sources below.  Barry’s analysis is more carefully qualified than that of most of the talking heads on CNBC.  Until now, I have always believed in the yield curve as an indicator, and I well know the peril in asking whether "this time is different."  That is where the causal modeling comes in. To review, here is the initial post:

Link: Inverted Yield Curve: Its different this time (not).

The yield curve, as measured by the ratio between the 10 and 2 year treasuries, is merely a few ticks away from inverting. This is something worth paying close attention to. What’s the significance of an Inversion? It reflects a decreasing demand for …

Readers can also check my comment on "Clear Thinking."  Everyone should understand that yield curve inversion theory is very strong and represents prevailing thought.  There is a good summary of the literature covering many questions about the relationship.  There is also a thoughtful analysis by a good blogging economist.

So why I am I taking a contrarian view on the indicator?  The problem with heuristics, and many studies do refer to yield curve inversion as a rule of thumb, is that without careful examination of the causal model, you do not know when the rule breaks down.  If you knew that the rooster died, you would not expect crowing at sunrise.

In this case, there is a widespread sense about a conundrum in the longer maturities.  If there are unusual factors affecting long rates, this time really is different.  The existence of these factors, summarized nicely here, is what frames the issue.

I believe that investors must constantly test every simple rule.  Last year, the January effect broke down.  "Three Steps and a Stumble" met a similar fate.

Our mission is not to take simple heuristics and follow them.  We are trying to find market inefficiencies by discovering when the simple rules break down.

That is the issue.  It is why I ask the question about whether we would like our economic prospects better if Asian banks dialed back purchases of our long maturities — or even sold them.  The last time there was a rumor about this, our market declined.

The inverted yield curve theorists cannot have it both ways.  If they accept the fact that long yields have been artificially suppressed (and that is what they are saying if they see inflation) then the rooster has died.

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One comment

  • Barry Ritholtz December 28, 2005  

    Like so many things in the Markets (and Life), an inversion is more complex than a 30 second tv snippet allows for.
    Yield curve inversions have invariably led to economic wobbles and slowdowns; More severe inversions (duration and depth) have led to recessions.
    So far, we have seen only a mild and shallow inversion. That’s a warning; If it deepens and continues, it will have more ominous implications
    This is the best explanation I;ve read to date: