The Yield Curve: The Best Recession Forecasting Tool

It was on the basis of this indicator that in the November 2006 issue of my Remnant Review newsletter, I predicted a recession in 2007. It arrived in December 2007, according to the National Bureau of Economic Research.

The yield curve is a "curve" of interest rates for debt certificates.

The interest rates for more distant maturities are normally higher the further out in time. Why? First, because lenders fear a depreciating monetary unit: price inflation. To compensate themselves for this expected (normal) falling purchasing power, they demand a higher return. Second, the risk of default increases the longer the debt has to mature.

In unique circumstances for short periods of time, the yield curve inverts. An inverted yield occurs when the rate for 3-month debt is higher than the rates for longer terms of debt, all the way to 30-year bonds. The most significant rates are the 3-month rate and the 30-year rate.

The reasons why the yield curve rarely inverts are simple: there is always price inflation in the United States. The last time there was a year of deflation was 1955, and it was itself an anomaly. Second, there is no way to escape the risk of default. This risk is growing ever-higher because of the off-budget liabilities of the U.S. government: Social Security, Medicare, and ERISA (defaulting private insurance plans that are insured by the U.S. government).

What does an inverted yield curve indicate? This: the expected end of a period of high monetary inflation by the central bank, which had lowered short-term interest rates because of a greater supply of newly created funds to borrow.

This monetary inflation has misallocated capital: business expansion that was not justified by the actual supply of loanable capital (savings), but which businessmen thought was justified because of the artificially low rate of interest (central bank money). Now the truth becomes apparent in the debt markets. Businesses will have to cut back on their expansion because of rising short-term rates: a liquidity shortage. They will begin to sustain losses. The yield curve therefore inverts in advance.

On the demand side, borrowers now become so desperate for a loan that they are willing to pay more for a 90-day loan than a 30-year, locked in-loan.

On the supply side, lenders become so fearful about the short-term state of the economy -- a recession, which lowers interest rates as the economy sinks -- that they are willing to forego the inflation premium that they normally demand from borrowers. They lock in today's long-term rates by buying bonds, which in turn lowers the rate even further.

An inverted yield curve is therefore produced by fear: business borrowers' fears of not being able to finish their on-line capital construction projects and lenders' fears of a recession, with its falling interest rates and a falling stock market.

An inverted yield curve normally signals a recession, which begins about six months later. The stock market usually begins to fall six months prior to any recession. So, the appearance of an inverted yield curve normally is followed very shortly by a falling stock market. Fact: The inverted yield curve is an anomaly, happens rarely, and is almost always followed by a recession.

There have been exceptions, as this report by the Cleveland Federal Reserve Bank indicates.

Here is a great page, published by Fidelity, that explains the four major slopes of the yield curve and how they form. There is even an animated graph that lets you run through almost 30 years of curves, month by month. You can click the Play button, and the graph scrolls by. Stop it at any point. Click here.

For skeptics who want a detailed explanation of the relationship between the inverted yield curve and recession, they can read a 2004 Ph.D dissertation by Paul F. Cwik, which is available on-line at The Ludwig von Mises Institute's web site.

The yield curve for U.S. Treasury debt certificates is the one that investors use to predict the economy. Investors assume that the Treasury is the safest lender -- the least likely to default -- and therefore the rates on Treasury debt are least affected by risk.

The Treasury publishes the various rates here: Treasury debt rates

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