Some economists have caught a case of recession jitters all because of what is happening to the so-called yield curve.
But the case for an economic slowdown based on interest rates is flawed, new research shows. That’s in part because the Federal Reserve is largely responsible for changes in the yield curve and at the same time, the Fed no longer has the power to shock the markets with its actions.
A recent report from financial research company HCWE & Co states:
The link between the slope of the Treasury yield curve and recessions is an example of correlation without causation.The common cumulative factor is Fed policy. And that lost its potency decades ago.
The yield curve measures the differences in interest rates on the U.S. 10-year Treasury note and the U.S. 2-year note. When the rate on the 2-year note is higher than the rate on the 10-year note, then the curve is said to have inverted.
Historically such inversions have often occurred right before U.S. recessions. And because of that, it is now taken as an article of faith among economists that this will always be the case. In other words, it’s now a given that an inverted yield curve will always signal a recession.
But the report, written by HCWE’s director of research David Ranson, makes a compelling case that such a view is wildly wrong.
His study finds that yield curve inversion happens exclusively due to changes in interest rate policy from the Federal Reserve. Put another way, the yield curve inverts when the Fed increases its short-term benchmark cost of borrowing. It has nothing to do with what happens to long-term interest rates, the report finds.
Ranson finds that once upon a time the Fed’s changes in short-term rates were highly connected to future growth. Over the period 1956 to 1987 increases in short-term interest rates were negatively correlated to a slowing economy in the following two years. Put simply, when Fed rates went up, and then the economy slowed.
But after that, over the period 1987-2015, the correlation vanished according to the analysis from HCWE & Co. Why? That’s because the Fed has taken to signaling far ahead of time what actions it will take, the report states.
Why has such a long-established relationship disappeared? Perhaps because the Fed relied in the past on the shock value of its interest-rate actions on a financial market that was far in size, depth, sophistication and resilience from it is today.
In other words, the Fed is now impotent to shock the market because it warns what it will do well ahead of time. As a result, everyone dependent on the markets works around the forthcoming changes.
The bottom line is simple — stop watching the yield curve as a signal for another recession.
Another important takeaway is that the Fed is not omnipotent when it comes to the economy.