Thought December 06, 2018 / 10:57 pm UTC

Signal From the U.S. Treasury Curve? Pick Your End-Points

By Kevin Harris

Recent market volatility features inversions to parts of the U.S. yield curve. To use the curve as a recession forecasting tool, one has to choose which maturities to compare. Mid-curve to short spreads signal earlier, but give false positives. More reliable segments of the curve are not signalling a recession.

Common wisdom among market professionals is that the yield curve is the best predictor of U.S. recession. To make best use of this wisdom, one should mind the maturities used. 

This month, the curve has inverted between 5y and 2y notes (Figure 1). 5y yields have not, however, fallen below the fed funds rate. Also, the commonly watched tens-to-twos and 10y-to-3-month spreads have not inverted (Figure 2). Which is right?

Figure 1: Fives Versus the Short-End (Arrows = False Signal)

Source: Federal Reserve, Continuum Economics

The fives-twos spread produced a false recession signal during the long expansion of the 1990s, so it is a good idea to look for confirmation from other spreads. For instance, fives versus twos have never correctly signalled recession without confirmation from the spread between fives and fed funds, which is currently at +55 bps. Also worth keeping in mind is that the spread between fives and fed funds produced two false signals in the 1990s, and two in the expansion of the late 1980s. 

Figure 2: Tens Versus the Short-End

Source: Federal Reserve, Continuum Economics

Comparing 10y yields to shorter maturities helps, but also requires care. The tens-to-twos yield spread tends to invert earlier than the 10y-to-3-month spread, but did produce a false signal in 1998. The 10y-to-3-months spread has not produced a false signal since at least the early 1980s. 

The upshot is that only the least reliable part of the curve is signaling recession. The most reliable spread, i.e., 10y-to-3-month, is still at +50 bps. No recession signal there.

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I, Kevin Harris, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.