Is economic winter coming? Look to the yield curve

Is economic winter coming? Look to the yield curve
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The Treasury yield curve is an excellent predictor of economic turning points.

While there are many different ways to calculate the yield curve, whatever transformation an investor uses all have the same basic characteristic: We compare the yield on a short-term Treasury security with the yield on a long-term security.

Our preference is to look at the resulting spread between 2- and 10-year Treasury notes, because we have found this specification to be the best predictor of the various yield curve transformations.

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When the yield curve is positive, it means that long-term rates are above short-term rates. At the moment this is the case, but barely so. Currently, the 10-year Treasury is yielding 2.96 percent compared to the 2-year Treasury, which is yielding 2.74 percent.

The 22-basis-point spread between the two securities is very low. In fact, it is basically hovering near its lowest reading for the current business cycle.

We have to look all the way back to October 2007, which was just before the economy went into recession, to find a similarly narrow positive spread between 2- and 10-year notes. So should we care?

In the past, when the yield curve inverted, meaning the yield on 2-year notes was above the yield on 10-year notes, the economy always went into recession.

It happened on average about 16 months after the initial inversion, although in the last business cycle the lead time was much longer — it took 22 months from a negative spread to coincide with the peak in the economy. Given this historical fact, investors then should care about the curve and when it inverts. But could this time be different?

There are a couple of reasons why the yield curve is such a good predictor of future economic activity. Most importantly, when the spread is negative, banks and other financial intermediaries tend to pull back on lending.

This is because these entities effectively borrow short and lend long. Put another way, an inverted curve means the cost of funding exceeds the rate that firms can charge on the loans that they make.

When this happens, the provisioning of credit dries up, and the economy dramatically slows. There is no reason to believe this time will be different.

The other reason why the curve has been so accurate in calling turning points relates to the wisdom of crowds. The Treasury market is the deepest, most-liquid market in the world and has been that way for decades.

Consequently, fixed-income investors in aggregate tend to anticipate events well before individual investors or policymakers do so.

This means that when the curve is inverted, the Treasury market is essentially making the bet that either the Fed will eventually dramatically cut interest rates and/or inflation pressures will meaningfully moderate.

Otherwise, there would be no reason for anyone to buy a long-term security such as the 10-year note when the investor could earn more by parking money in the shorter-end of the curve (i.e. the 2-year note).

For these reasons, investors must remain on the lookout for the possibility of yield curve inversion perhaps as soon as the end of this year. While this would not necessarily point to recession next year or even early 2020, the historical record of the yield curve would augur for caution thereafter.

Joseph LaVorgna is the chief economist for the Americas at Natixis, an international corporate and investment banking, asset management, insurance and financial services arm of Groupe BPCE, the 2nd-largest banking group in France with 31.2 million clients spread over two retail banking networks, Banque Populaire and Caisse d’Epargne.