Its Different This Time Redux

Deustche Bank joins the list of pundits who have opined that "Its different this time."

In their Daily Economic Note, the Banks Economic research department opines that investors should Not Read Too Much Into the Flat Yield Curve:

The yield curve has been a terrible predictor of GDP growth
over the last 15 years. The
chart below shows a rolling correlation coefficient between
the slope of the yield curve and the growth rate in real GDP.

To calculate this we measure the yield curve as the basis
point difference between the yield on the 10-year Treasury note and the Fed
funds rate. We compare the slope of the yield curve to the growth rate in real
GDP over the following year.

In the 1970s and 1980s, the yield curve was a very good predictor
of the economy, evidenced by a very high correlation coefficient between the
two series when it was consistently around 80%. The correlation coefficient
started to break down in the early 1990s and actually went negative in 2001. It
has improved somewhat, but remains well below where it was.

I do not want to critique any single indicator, nor do I have any bones about the criticism coming out of Deutsche Bank.

Instead, I want to point out this once removed chart they have created of the Yield Curve, torturing it somewhat to produce the graph below:

The Yield Curve’s Predictive Power has Vanished
click for larger graph

Source:  DB Global Markets Research

Their position that a flat yield curve is not a good predictor of GDP is a strawman; Note that this is not how investors (I cannot speak for economists) primarily use the curve. Whent he Curve gets inverted, that’s when investors should sit up and take notice.

Its worth pointing out that the yield curve is actually more than one variable; its a combination of two factors: short interest rates, which reveal the Central Bank’s economic expectations. And, its a function of long rates, which  embodies the Bond Market’s economic expectations.

What we have seen historically is that the Yield Curve, when it gets
inverted, is a fairly reliable predictor of recessions. And we know what recessions do to the stock market.

So whether or not a flattening Yield Curve itself is a good predictor of GDP is rather irrelevant to me (and to other investors).

Instead, watch for the relatively rare and aberrational inversion that may take place in the future. If and when that happens, I have one word for you:  Sell.