Conventional wisdom suggests that US recessions usually follow an inverted yield curve. This is not surprising: Since 1960, seven US recessions have been preceded by an inverted yield curve. Given that the US yield curve has once again inverted, should we therefore assume that a recession is on its way?
I advise caution. The latest US yield curve inversion has occurred after a decade of large‑scale government bond purchases (quantitative easing (QE)) by the Federal Reserve (Fed), the Bank of England, the Bank of Japan, and the European Central Bank.
Both historical precedent and our own internal modeling suggest that the presence of these central banks in their respective bond markets as a buyer of last resort allows for the possibility that term premia (the risk premia that investors require to hold a long‑term bond to maturity) are much smaller and less reactive to macroeconomic news. It is therefore plausible that yield curve inversions in the age of QE may not have the same predictive qualities as in the past.
Bloated central bank balance sheets may scramble the inverted yield curve signal
To test how effectively inverted yield curves have predicted recessions in the post-Bretton Woods era, we recently examined yield curve inversions associated with varying levels of sovereign debt held by G7 central banks since the early 1970s.
Simple correlation analysis shows that when the central bank owns close to 0% of sovereign debt, the correlation between the yield curve and recession four quarters ahead is -0.5. On the other hand, when the central bank owns close to 10% of government debt, the correlation between the yield curve and recession four quarters ahead is close to zero.
The crucial impact of government debt
Yield curves negatively correlated with recessions when the share of sovereign bonds on central bank balance sheets is low
Source: T. Rowe Price.
These simple correlation results, showing that an inverted yield curve loses predictive power for recessions when the central bank owns around 10% of government debt, also emerge when we apply more sophisticated econometric techniques.
Making sense of mixed signals
Yield curves are negatively correlated with recessions only when the share of government debt on central bank balance sheets is low.
The chart below shows how these insights affect the conclusions of the NY Fed’s model of recession probability model, which provides the probability of recession 12 month ahead based only on the spread between the 3-month US treasury bill and the 10-year US treasury bond. Given that this spread inverted in Q3 2019, the NY Fed approach (dark blue line) implies a probability of recession of 48%, which is similar to the probability of recession this approach implied in 2007, right ahead of the global financial crisis.
Recession probability implied from our research
How predictive is the current yield curve inversion?
Actual results may vary, perhaps significantly.
Source: T. Rowe Price, International Monetary Fund, and New York Federal Reserve.
However, when this is adjusted for the presence of government debt on the Fed’s balance sheet, the model implies a reduced probability of 32%, similar to the signal sent in the late 1990s when the Federal Reserve cut interest rates to extend the expansion mid-cycle. This conclusion is also in line with recent rhetoric by Federal Reserve Chairman Jerome Powell about the situation today.
Overall, historical experience combined with our empirical analysis of more recent data in the G‑7 imply that yield curve inversions do not have the same predictive power for recession when central banks hold double‑digit shares of government debt.
Importantly, this does not mean that the probability of recession is lower, but rather that an inverted yield curve does not have the same predictive power as before.
What does this mean in practice? Rather than only relying on yield curve inversion, investors should put greater weight on macroeconomic fundamentals to assess recession risk. These continue to suggest that the risks of a US recession within the next year are low.
What we’re watching next
The main lesson from this analysis is that in the age of QE, the yield curve is likely a less reliable predictor of recessions than in the previous five decades. The new dataset collected here will also allow us to examine which variables continue to predict recessions in the age of QE. This is where our analysis will likely go next.
For professional clients only. Not for further distribution.
This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.
The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.
Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.
The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.
It is not intended for distribution to retail investors in any jurisdiction.
This material is issued and approved by T. Rowe Price International Ltd, 60 Queen Victoria Street, London, EC4N 4TZ which is authorised and regulated by the UK Financial Conduct Authority. For Professional Clients only.
© 2019 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the bighorn sheep design are, collectively and/or apart, trademarks or registered trademarks of T. Rowe Price Group, Inc.
See our comprehensive range of US equity funds