The yield curve is first and foremost predicting the outlook for Fed policy rather than the next recession. My research has confirmed this conclusion, as does a recent Fed study.
1. Original note: Last year, the minutes of the June 12-13 FOMC meeting offered a reason not to worry about the flattening yield curve at that time. During the meeting, Fed staff presented an alternative “indicator of the likelihood of recession” based on research explained in a June 28 FEDS Notes titled “ The Yield Curve” by two Fed economists, Eric C. Engstrom and Steven A. Sharpe. In brief, they questioned why a “long-term spread” between the 10-year TMUBMUSD10Y, -0.
In addition, they report: “Its predictive power suggests that, when market participants expected — and priced in — a monetary policy easing over the subsequent year and a half, a recession” was likely forthcoming. The near-term spread “predicts four-quarter GDP growth with greater accuracy than survey consensus forecasts. Furthermore, “it has substantial predictive power for stock returns,” find the Fed economists.
The yield-curve spread tends to narrow during periods when the Fed is raising the federal-funds rate . It tends to bottom and then widen when the Fed starts to lower interest rates. It just so happens that past recessions occurred after the yield curve inverted, i.e., at the tail end of monetary tightening cycles.
5. Missing in action: The Fed study notes: “We define the near-term forward spread on any given day as the difference between the implied interest rate expected on a three-month Treasury bill six quarters ahead and the current yield on a three-month Treasury bill.”
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