January 30, 2008 / 6:54 PM / 11 years ago

As US recession looms, yield curve looks prescient

NEW YORK, Jan 30 (Reuters) - When short-term U.S. interest rates crept above their long-term counterparts in 2006, many economists dismissed the long-held harbinger of recession thinking their crystal balls were busted.

Other economic signals were flashing good times, so why was this sign of gloom making an unwelcome appearance? A solution emerged: dismiss the trend, and find reasons why things were different this time.

Except they weren’t. As a housing-led credit spiral has brought growth near a halt, it looks as though the interest rate tarot cards were right on the money.

The U.S. economy expanded at just a 0.6 percent rate in the fourth quarter, and for all of 2007 posted its weakest showing in five years.

Until recently, though, the recent inversion of the yield curve had been dismissed as a fluke, despite four of the past five such episodes having preceded the last four U.S. recessions.

So persuasive was the newfound consensus on the curve’s waning powers as forecasting tool that The Conference Board, an economic research firm, gave it less weight when calculating its Index of Leading Economic Indicators.

“There was this widely held belief that somehow longer-term Treasury rates were just artificially low, so the signal from the inversion was not viewed as relevant,” said Keith Hembre, chief economist at First American Funds in Minneapolis, Minnesota. “Now we’ve got a pretty weak economic environment ahead of us, and a recession is likely this year.”

It wasn’t just Wall Street that believed the yield curve’s years of service as a recession indicator were due for a forced retirement. Both Federal Reserve Chairmen Ben Bernanke and his predecessor Alan Greenspan embraced the idea.

“I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come,” Bernanke said in his first speech to Wall Street as head of the Fed in March 2006.

He was essentially repeating the Greenspan mantra, captured in what was perhaps the last of the Chairman’s many famous catch phrases: the conundrum. In this view, unusually high savings in Asia and concomitant purchases of Treasury debt by overseas central banks, not the prospect of recession, was behind the anomaly in yields.

Normally, lenders demand higher interest rates for longer-term loans. When the yield curve inverts, borrowers must actually pay more to borrow over short periods, depriving banks of a key source of profits.


In this business cycle, the inversion never relatively deep. At its November 2006 trough, the yield spread between 10- and two-year Treasury notes fell to about minus 16 basis points. In contrast, that differential was as deep as minus 50 basis points ahead of the 2001 recession.

This shallowness bolstered the newly formed consensus maintaining that there was nothing to worry about.

Yet around 18 months after a consistently inverted yield trend emerged, just the sort of time lag typically seen between a full-blown inversion and recession, the yield curve is showing its predictive powers are not to be messed with.

“The whole thing is surreal. In the last four weeks the whole world realized we were going into a recession,” said Richard Gilhooly, senior bond strategist at BNP Paribas. “Our economists have been talking about it for a year and a half.”

To be sure, the economy has not yet contracted, though Wednesday’s GDP data shows recent growth has been negligible at best. And, with unemployment on the rise and retail spending showing signs of exhaustion, many now believe the economy’s fate is sealed.

In fact, some investors including PIMCO fund manager Bill Gross believe the economy began contracting in December.

By all accounts, a recession in corporate profits is already here. Under the weight of more than $100 billion in mortgage-related write-offs in the banking sector, Reuters Estimates now forecasts fourth-quarter profits among S&P 500 companies will drop nearly 18 percent, threatening to wipe out all of the gains in the three previous quarters.

A decline in earnings growth in 2007 would be the first since 2001, a recession year when earnings declined 15.79 percent. Richard Bernstein, chief investment strategist at Merrill Lynch, has noted that, even for the unbelievers of the curve’s macro forecasting abilities, its hunch for a profits recession is foolproof.

Not everyone is a convert though. Stephen Stanley, chief economist at RBS Greenwich, says the curve’s premonition may have been happenstance. He argues that the extent of the current financial crisis, which has brought the economy to a tipping point, was difficult to forecast. Nonetheless, he acknowledges it is a notable coincidence.

“There will be some who will point to the yield curve as having been an accurate predictor,” Stanley said. “Maybe you could argue that there were some people who were really pessimistic about the long-term outlook and they had it all right. I’m not convinced.” (Editing by Tom Hals)

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