One popular recession indicator, the yield curve
Many investors may have seen in the media reports that the yield curve could be sending a warning signal. The metric at hand measures how steep, flat, or even inverted the yield curve might be. The most popular measure of the steepness of the yield curve (though there are others) is the difference between the yield of the 10-year Treasury and the 2-year Treasury.
The thinking goes that when this measure is high and longer term rates are greater than shorter term rates, investors expect the Fed to possibly raise rates in a growing economy. And the reverse would theoretically be true, too, when a negative value in this measure would mean investors expect the Fed to cut rates in a slowing economy or even recession.
Historically, this measure had sent mostly accurate signals, though not always. There are other reasons why the yield curve could be flat, and ones that aren’t directly caused by economic growth forecasts.
Why investors usually demand a premium for investing in longer term bonds
One big reason why investors usually demand higher yields from longer term bonds is that a longer term bond’s price is more sensitive to changes in interest rates than that of a shorter term bond. After all, a change in interest rates will affect investors’ income stream for a longer period.
Thus, investors demand a premium in yields for owning a longer term bond, known as the term premium. This is basically the difference between the yield on, say, a 10-year Treasury bond and the expected yield of owning a series of one-year Treasury bonds for that 10 year period, rolling each one over at maturity. It’s an estimate that requires calculations, of course, but we can obtain values for this metric through many securities data providers.
Since we know that investors require a premium to own a longer term bond to compensate for risk, we might expect that the term premium is correlated to measures of bond market volatility. And indeed, it is, using a popular bond market volatility indicator from Merrill Lynch, known as the MOVE index. This is illustrated in the nearby graph.
Why is bond market volatility expected to be lower now?
The Fed has done an excellent job of telegraphing its expectations for the future levels of interest rates it sees (though knowing that any forecast can be mistaken). And investors seem to believe the Fed’s consistent messaging over the course of recent years that interest rates would continue to be low well into the future, lower than where they were in previous cycles.
By demonstrating persistent conviction in this view, the Fed may have reduced expected volatility in bond markets. Giving investors greater confidence in the direction and magnitude of any changes in interest rates and bond yields has then led to investors demanding a smaller term premium.
Lower volatility can mean a flatter yield curve
Moving on to the next consideration in this thesis, consider the relationship of the term premium with the steepness of the yield curve. Naturally, we might expect that if investors are demanding less of a premium to own longer term bonds versus holding shorter term instruments, the difference between long- and short- term bonds would be less.
And yes, this is the case as well, as seen in the nearby graph that illustrates the relationship between the term premium and the yield curve, using the difference of yields of the 10-year minus 2-year yields to gauge its steepness.
But economic weakness might also be a factor, too
But could the yield curve be accurate in signaling a potential recession? Let’s look at the yield curve superimposed on a different set of data, that relating to consumer confidence, with data from The Conference Board.
Consumer confidence data might be more useful if we think about not just what consumers think about how things are now, or how things will be in the future, but how things might change from now to get to where they’ll be in the future. If consumers expect things to get better by a lot, they’ll spend more than if they expect things to improve by just a little bit, not to mention what their behavior might be if they believe conditions will actually worsen.
The consumer confidence data includes many different data points besides the headline statistic. Among these are measures for “expectations” of conditions in the future and for the “present situation”. Taking the difference between the two gives us that measure we discussed above, the direction and magnitude of changes to their circumstances consumers expect between now and six months into the future.
This calculation can give us a potentially more-accurate recession signal than isolated consumer confidence statistics, and we can see this relationship in the nearby graph. Interestingly, as you’ll note in this graph, this measure is neatly correlated to the yield curve. And both of these metrics reached their nadir shortly before a recession began.
So, what do these data tell us this time around? We’ve gone through an exercise where we have a perfectly rational alternative explanation for why the yield curve is so flat: volatility is expected to be low, and perhaps the yield curve is not a harbinger of economic doom.
But we also see how the steepness of the yield curve is correlated to economic expectations derived from consumer surveys, which has historically signaled recessions. One data set, but two different explanations and two different conclusions. And that is why finding a simple recession indicator is just, well, complicated.
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Source: Data on securities prices and market indices comes from Bloomberg and/or the U.S. Federal Reserve, unless indicated otherwise.
MOVE Index: Merrill Option Volatility Estimate. This is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of volatilities on the 2 year, 5 year, 10 year, and 30 year Treasuries. `MOVE' is a trademark product of Merrill Lynch.
Term Premium: Investors usually demand a premium in yields for owning a longer term bond, known as the term premium. This is basically the difference between the yield on, say, a 10-year Treasury bond and the expected yield of owning a series of one-year Treasury bonds for that 10 year period, rolling each one over at maturity.
Consumer Confidence: The U.S. consumer confidence index is an economic indicator published by The Conference Board to measure consumer confidence, which is defined as the degree of optimism on the state of the U.S. economy that consumers are expressing through their activities of savings and spending. Besides the headline figure, the data includes a number of components, including one that measures how people feel right now, and another that measures their expectations for the future.
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