Yield Curve Says Probable Recession

John Mauldin notes:

"The yield curve became more inverted this week, with the negative differential between the 3-month and the 10-year at -49 basis points and a -76 basis point differential between the 10-year and the Feds fund rate. According to a Fed paper, that level of an inversion suggests there is now an over 40% probability of recession next year. This same model only predicted a 50% chance of recession in 2000, and as the paper authors acknowledge, the model probably understates risk in recent decades."

The yield curve and interest-rate data looks like this:


So the question for those who believe markets are future discounting mechanisms: Which market are you going to believe: Stocks or Bonds?


Honey, I Created A Bubble
John Mauldin
Investor Insight, November 10, 2006

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What's been said:

Discussions found on the web:
  1. BamBam commented on Nov 11

    Does the fact that the Fed knows the past probabilities of recession associated with certain yield curve slopes change the future probabilities?

  2. mh497 commented on Nov 11

    Imagine what would happen to housing if the yield curve weren’t inverted, and longer term rates had a more normal relationship to shorter term rates.

  3. ECONOMISTA NON GRATA commented on Nov 11

    Just look at what’s happening to housing as is… “The train has jumped off the tracks, it is heading for a cliff with a big ditch at the bottom”. Let’s just hope that it lands right side up… I think that that’s the best we can hope for…



  4. Leisa commented on Nov 11

    BR, is it really either or? Perhaps we can believe neither. If we are going to have stagflation, will not both markets be wrong?

  5. fiat lux commented on Nov 11

    It’s been almost a full year since the yield curve started to invert. When does the recession start?

  6. Ivany commented on Nov 11

    “It’s been almost a full year since the yield curve started to invert. When does the recession start?”

    A month or two ago.

  7. Estragon commented on Nov 11

    I wonder if the yield curve is just one element of a continuing reduction in risk premia generally.

    In a simpler time, bank reserves were set at a level which, in theory, prevented systemic risk caused by loan defaults. Raising or lowering reserve requirements was one way of influencing money supply and risktaking. An decrease in reserve requirements would increase the supply of money available for lending, increase the willingness of banks to make risky loans, and reduce interest rates. Central banks could monitor money supply relatively easily by monitoring bank balance sheets.

    Financial innovation has had the apparent effect of damping volitility and spreading risk such that the price of most types of risk has been bid down. In a sense, this could be thought of as a reduction in the reserve requirement of the world financial system. The effect of this might be similar to a decrease in bank reserve requirements. Unlike the simpler times though, the diffusion and complexity of money creation has outrun the ability of central banks to measure it.

    IF risk has been permanently reduced, both the equity and debt markets could be “right” in that the price of these assets simply reflect the reduction of risks inherent in them. Obviously, if it turns out that risk isn’t gone, but is only mispriced and hiding in complexity, the results could be nasty.

  8. Paul Jones commented on Nov 11

    An apolitical fed might have cut rates because of your interperetation; would a rate cut be in the long-term interest of the economy?

  9. V L commented on Nov 11

    Severely de-industrialized and extremely indebted US economy is barely hanging on the brink of collapse. Contrarily to Wall Street cheerleaders theme, it appears that global economy is not much stronger. (I also see a recession in China after 2008 Olympics.)

    In addition to US, Eurozone yield curve also inverts

    French Economic Growth Unexpectedly Stagnates

    Japan Machine Orders Unexpectedly Slump

  10. anon commented on Nov 11


  11. mentalmodel commented on Nov 11

    The agency problem created by the sale of loans is something that I think deserves a bit more attention. While loan sales certainly spread risk, they can give rise to weaker credit standards. Those originating loans that will be put up for sale aren’t as likely to be as dilligent about evaluating default probability — this incentive doesn’t really exist for as the risk is going to be sold off. The last time I checked, financial engineers haven’t really solved the problem of estimating correlation of risks in their tranches without expending infinite amounts of computer time.

  12. Idaho_Spud commented on Nov 11

    Barry Barry Barry…

    Irving Fisher has a PhD in economics and stated that we are “at a permanently high plateau”, and so who are we to doubt him?

    An ex fed chairman says that the yield curve “no longer has the predictive value it once had “, and so who are we to doubt him?

    These are very wise men of high finance, you know ;)

  13. my1ambition commented on Nov 11

    BR, I’m getting too depressed. Could someone please show me some positive data?

  14. V L commented on Nov 11

    “I’m getting too depressed.”

    If you think this was depressing, just you wait how depressing it is going to get when CNBC market cheerleaders will turn into market funeral directors.

    A little bit of history: The NASDAQ Composite CRASHED another 9.7% on 04/14/2000, capping the week’s total loss at a stunning 25%!
    Senior Market Cheerleader turned Chief Market Funeral Director Jim Cramer: “…This is, by the way, a real crisis…” and “…I am heartsick…” and “…this kind of hammering has your head ringing…” etc.


  15. Mr. Beach commented on Nov 11

    George Soros has tried to educate the world about his theory of reflexivity. In essence, he argues that in a rapidly rising market a positive feedback loop replaces underlying fundamentals — e.g. risk premiums fall because defaults are low — defaults are low because risk premiums are falling.

    To Soros’ observation, it is interesting to consider that we are a Nash equilibrium (John Nash, mathematician, A beautiful mind, game theory…).

    A Nash Equilibrium exists when no player in a game can improve their lot while other players keep on doing what they’re doing. The game is stable at a nash equilibrium point.

    Is the current state of affairs a Reflexive Nash equilibrium? In other words, is it possible that the market is stable — even though it is NOT priced rationally according to fundamentals?

    My econ professors on the river Charles would have said NO. Prices are always rational. Unfortunately, traditional macro does not allow for trillion dollar players to make non-economic decisions.

    IMHO, in defending their currency, the Chinese have established a Reflexive Nash equilibrium. It is in everyone’s interest to play their roles as they have been. Anyone stepping out of the roles by betting against the dollar or against bonds has gotten hurt by the market.

    Lastly, the length of this stable period has driven the market reflexively.

    The only way the equilibrium point changes is if the rules of the game change.

  16. charts commented on Nov 12

    I’m suprised you didn’t show the UK’s curve too. That’s more inverted.

    Or Australia’s…also inverted.

    And now the Eurozone just started to invert.


  17. Michael C. commented on Nov 12

    >>>BR, I’m getting too depressed. Could someone please show me some positive data?<<< Don't be depressed. All this negative data is ignored and is actually positive for the economy. The weak economy will mean lower rates which will save the housing market which will in turn save the economy. It's the positive data that you should be worried about. It's actually negative since it understates inflation as BR has been showing. When the Fed realizes this and is forced to keep raising rates, it will bring stagflation and an end to the economy as we know it. That is what keeps me going. Along with the double glass of scotch at the end of the day.

  18. wunsacon commented on Nov 12

    Mr. Beach,

    I would like to learn more. Where did you learn of Soros’ views: in one of his books or elsewhere?

    I can search for items myself. But, what do you recommend reading?


  19. Macro Man commented on Nov 12

    Before driving the final nail into the coffin of the US economy on the basis of an inverted yield curve, ask yourself who is buying bonds, and whether they are profit maximizing agents. At least most participants in the equity market are (at least notionally) profit-maximizing.

    China by itself accrues $20 billion a month in foreign exchange reserves, of which maybe half of that finds its way into the US Treasury market, either through direct participation at auction, via purchases though third party banks (which may not be captured in the TIC data), or via mandates to third party bond managers (which also are unlikely to be captured in the TIC data.) While this may not impact the SHAPE of the yield curve, it certainly impacts the LEVEL of the yield curve, which is also important. A number of studies have suggested that the influence of central bank flows has taken something on the order of 50-75 bps off of the 10 year yield.

    Meanwhile, pension funds worldwide are short duration and provide a virtually permanent bid for the long end of the curve. One can observe this phenomenon in Japan, the UK, Europe, and the US. This pension fund bid is not profit-maximizing, but rather short gamma- i.e., the lower bond yields go, the more bonds these guys have to buy. In the UK, for example, a 50 year gilt yielded as low as (roughly) 3.5% a while ago, taking the yield well through the entire rest of the curve. The rationale was not a desire to lend money to Gordon Brown at a ludicrous rate, but rather buying triggers resulting from an increase in the NPV of liabilities.


    Click there or on my name to see a few charts illustrating the predictive ‘power’ of yield curves in other Anglo-Saxon economies. As Estragon pointed out above, the yield curve in the UK has been inverted for most of the last nine years (with a housing market that has seen the same kind of doom and gloom prognostications as the US, incidentally), but there hasn’t been a recession since the early Nineties.

    Trichet made an interesting observation in the Q&A of the last ECB press conference. Tradtionally, he observed, we think of investments chasing (i.e., trying to attract) capital. With the savings glut created by reserve accumulation in Asia and the Middle East, we have now reeached a situation where capital is chasing investments.

    And before anyone objects, yes I am aware that there are near-record longs in the 10 year note futures according to the CFTC data. However, I would submit that many of those longs are owned by momentum-driven funds. Technically, they are indeed profit-maximizing, but of course they only look at price, not ‘fundamentals.’ Anecdotal surveys, such as the Merrills survey and the Russell/Mellon survey, show a persistent bias amongst active bond managers to be short US bonds.

    Maybe this time isn’t really different after all…but it still begs the question of why inverted yield curves in other countries have failed miserably to signal impending doom in any sort of timely fashion.

  20. blam commented on Nov 12

    The Central Banks of the world are the source of the of the riskless “risky” asset. Their continued massaging and recasting of the data, in conjunction with inflationary actions, have created an implicit “put” on financial assets, resulting in the final bubble of this go round.

    Rather than allowing markets to correctly price equities last June, the CB’s have pumped the financial markets with monetary expansion to the point of no return. Adding the sum of the crash in the housing bubble and a likely equity crash will ensure that the end game is much more ugly than would have been necessary.

    Once speculative interests are allowed free reign in the markets, the disconnect between value and price is at first intoxicating. New definitions of risk emerge to explain away the disconnect. Like the NASDAQ, equities have reached a relative price extreme, which can only be justified by a redefinition of risk.

    I think the bond market probably has it right.

  21. bushsux commented on Nov 12

    Wuns- Try reading Soros’ book The Alchemy of Finance.

    Mr. Beach is a better writer though so we should perhaps just query him.

    I agree that China is the player to watch but what are the triggers to look for? No one in China calls me up and lets me know what they are up to.


  22. Leisa commented on Nov 12

    I was reading Chris Dialynas’ (Pimco) piece from Spotlight 02/2006. There were some points relative to the discussion at hand regarding liquidity that readers here may find of interest. Dialynas discusses the excess liquidity in the system. Because there is increased investment risk, notably from uncertainties regarding Iraq war, war on terror and China’s political/economic future, that that liquidity is getting pumped into more liquid assets–bonds of industrialized countries. He also made another interesting comment that there is risk priced into the stock market—to be understood by the S&P 500’s P/E multiples failing to expand. He attributes the housing bubble as the manifestation of inflation in the system

    I suppose that the need to invest in “safe” assets and lack of investment opportunities with acceptable risk profiles are credible explanations as to why longer term rates have managed to stay low. Maybe there is a “it’s different this time” with respect to the yield curve inversion presaging a recession, and that attributing the low level of long term interest rates to expectation of recession might be wrong attribution.

    I do not pretend to know, but I found the paper interesting.

  23. Eclectic commented on Nov 12

    All comments appear to be good thoughts:

    Here’s another approach to a possible reason for the inverted curve:

    I think it may be explained by examining the effects of overly aggressive use in the U.S. of faulty pro-forma EBITDA accounting. Bear with me; I’m not an accountant.

    Industries destined to close (or to relocate plants out of the U.S.) do not fully recognize what is the true costs of continuing to operate them in the U.S. between the time closure decisions are made and the time they are finally closed.

    In other words; for these industries and/or plants the equations used to determine EBITDA no longer have to account for depreciation and amortization of plant and equipment (at least a lot of these costs, if not nearly all), because, at the moment decisions were made that these plants would be closed, the operators mentally dropped ‘D’ and ‘A’ out of the equation, forever, regardless of when the official accountancy would at a later time reflect the charges.

    EBITDA thus becomes just EBIT as a mental exercise and planning tool. Even the ‘I’ and ‘T’ may also drop out when fixed interest charges related to production can not be avoided by closing the plant, and possibly if government has awarded special tax treatments for plants that continue to operate.

    In any event, much of ‘D’ and ‘A’ become phantoms, since they no longer have to be serviced, and this allows the continued production operations at plants, and thus continued employment, when the employment would be shut down immediately if the costs had to be capitalized traditionally. This is even more important for operators who would suffer politically from discontinuing employment, and they would thus operate at bare breakeven in order to just recover variable costs of production.

    Since the plants are destined to be closed… the employment at them is just as destined to be terminated, and in the interim, since employment costs are not sufficiently high enough to push EBIT into the negative without the negative contributions of ‘D’ and ‘A,’ plants are allowed the convenience of continuing to operate when they would otherwise have closed.

    Since there are no plans for capital expenditures to upgrade or replace these facilities, there is no capital borrowing to finance them.

    At the margins, the effects of these observations is that long-term rates do not respond to the demands for capital expenditures by rising as the Fed has expected.

    The short end is far more mechanically controlled by the Fed, rightly or wrongly, and, responding to the inflationary forces of U.S. consumerism that have modulated capital expenditure outside of the U.S. (rather than new expenditures of ‘D’ and ‘A’ inside the U.S.) the Fed is attempting to slow capital expenditures that they can not affect. In other words; the Fed’s affects on working capital (the larger contributor to short rate movements) are having no effect on slowing offshore cap-ex, which is itself insulated from domestic cap-ex.

    The result is a very bizarre animal; a domestic cap-ex liquidity trap, combined with a worldwide excess productive capacity… and a toothless Fed with no effective tools to deal with it.

  24. winjr commented on Nov 12

    “As Estragon pointed out above, the yield curve in the UK has been inverted for most of the last nine years (with a housing market that has seen the same kind of doom and gloom prognostications as the US, incidentally), but there hasn’t been a recession since the early Nineties.”

    If this discussion had been held exactly 5 years ago, the above statement could have read “the yield curve in the UK has been inverted for most of the last 4 years …” Would have sounded just as convincing, no? Still, the yield curve inverted at the end of 2000, and a recession followed the next year.

    Since 1960, I count 7 instances of yield inversion. of these 7 instances, 6 resulted in recession. The only failure was 1966. (In 1966 housing starts also plummeted, another reliable indicator of recession, but it would appear that cranking up the Vietnam war machine saved the day.)

    “but it still begs the question of why inverted yield curves in other countries have failed miserably to signal impending doom in any sort of timely fashion.”

    I agree. But I’m not sure the question is even relevant when asked about a country whose account deficit as a percentage of GDP is only a small fraction of ours.

  25. ECONOMISTA NON GRATA commented on Nov 12

    Busy week, next week. Lot’s of numbers. Plenty to talk about. Regardless, everything is pointing toward a severe recession, severe because, as has been discussed here on many, many occassions, cause and effect. Primary cause, housing, effect, recession. This animal is too big and I am reasonably certain that we do not have anything in our arsenal to hunt it down.



  26. Douglas Gammons commented on Nov 12

    Check out this short article about the yield curve posted in MarketWatch.com. It quotes Lakshman Achuthan from ECRI as saying “The yield curve doesn’t pass our test to be included in our leading indicators”. This comment really surprised me because I thought it would be one of his most important leading indicators. http://www.businesscycle.com/news/1065/

  27. Ironman commented on Nov 12


    If you’re interested, here’s a link for an online tool where you can plug the numbers in yourself to check on the probability of a recession using federal funds rate and Treasury yield curve data:

       Reckoning the Odds of Recession

  28. Digital Breakfast Creating Wealth Everyday commented on Nov 13

    Inverted Yield Curve A List Bloggers Catch On

    Barry Ritholtz of the Big Picture is an A list market blogger and I highly respect his thoughtful and thorough posts. However, I have to take a moment and pat myself on the back for pointing out the inverted yield curve story first. I st…

  29. Macro Man commented on Nov 15

    Better late than never:

    For what it’s worth, the latest data suggests the US with a c/a deficit of 6.4% of GDP, Australia with a c/a deficit of 5.6% of GDP, New Zealand with a c/a deficit of 9.6% of GDP, and the UK with a c/a deficit of 2.8% of GDP.

    So the yield curve has failed to predict recession for countries with current accounts both larger and smaller than that of the US as a percentage of GDP. The persistent inversion of the UK curve since 1997 is the result of pension legislation passed in the late 90’s, which requires UK pensions to susbtantially increase the fixed income weighting in their portfolios. Pension funds in other countries, including the US, have adopted a similar approach. This, combined with the persistent Asian central bank bid for sovereign bonds, is why one should have reservations about mechanically forecasting recession.

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