Will the Yield Curve Still be Helpful Going Forward?
The Federal Treasury Yield Curve has historically been useful in predicting recessions in the United States. However, I think there are reasons to believe it may not be helpful going forward. There are two reasons. The first is that monetary policy is now implemented differently. The second is that fiscal policy is now more actively used to manage the economy.
In this article I will:
explain what the yield curve is;
show how it has predicted previous recessions;
give the rationale;
explain the first reason the rationale might not work (new way of doing monetary policy); and
explain the second reason (more active fiscal policy).
What Is the Yield Curve?
When economists use the term “curve” they really mean graph. So, for instance, the terms “demand curve” or “supply curve” really mean graphs of the quantity of a good which is demanded or supplied, respectively depending on some other measurable thing. That other measurable thing for supply and demand “curves” (graphs) is usually price. Similarly, the yield curve is a graph of yield, i.e. the interest rates on bonds. For the yield curve, the variable that yield is graphed against is the duration of bonds.
For example, according to the Treasury, at market close on June 23rd 2021, the yield on a 30 year bond was 2.11%; and the yield on the 20 year bond was 2.04%. Hence, the yield curve (graph) could include a point indicative of a duration of 30 years and a yield of 2.11% and another point of a duration of 20 years and a yield of 2.04%. Such a graph is shown below.
Predicting Recessions With the Yield Curve:
Usually, the Yield Curve is upward sloped, meaning that the higher duration bonds have a higher interest rate on them. When this trend is reversed it has historically been a signal of a recession. This reversion is called a “Yield Curve inversion.” I’ll get into the rationale behind this below. In short, a Yield Curve inversion signals tight monetary policy which will suppress Aggregate Demand leading to a recession.
You can see in the chart below the Yield Curve’s good track record of predicting recessions. What is charted is the interest on the 10 year government bond minus the interest on the 1 year bond, over time. The grey areas are officially designated recessions. When the 10 year yield is lower than the 1 year yield this means the below graph dips below the x-axis, and as we see is a pretty good indicator that a recession is not far off.
Rationale for Inverted Curve Signaling Recessions
First, let’s introduce the critical notion of the overall level of spending on goods and services made in America. This is sometimes called “Aggregate Demand” or just “Demand,” and it can cause a recession if it is too low or overly high inflation if it is too high.
Both monetary and fiscal policies have been tools used by the government to increase or decrease the Aggregate Demand, although factors outside of the government's control can also impact it. Aggregate Demand could go lower because of contractionary fiscal policies like tax hikes and spending cuts. It could also go lower because of contractionary monetary policies which raise interest rates.
In fact, the way monetary policy was historically implemented can explain why a yield curve indicates a contractionary monetary policy, which could feasibly lead to a recession.
Historically, the FED has set one interest rate directly and allowed the changes in that interest rate to filter over to other interest rates, with different durations and levels of risk. The Federal Funds Rate, an interbank lending interest rate on very short-term loans, was officially designated as the “policy rate” of the FED and all FED actions could be understood in terms of that interest rate.
When the FED holds the Federal Funds Rate high and indicates it will raise it higher, that causes banks to sell bonds, as they can make more money by lending at the FED rate. Cheaper bond prices push the implicit rate of return on bonds up. Banks do this with risky corporate bonds, mortgages and with safe government bonds.
Similarly, if the FED is pushing the Federal Funds Rate down, the opposite happens and bond yields go up.
Similar mechanisms cause repricing on the interest rates on bank loans, bank deposits and mortgage interest rates. Furthermore, student loan costs are pegged to the interest on the 10 year treasury bond.
Through this process, the FED would allow changes in the Federal Funds rate to trickle out through the banking system into all lending markets in the economy.
Because the FED tightens policy by moving short-term interest rates up, when short term interest rates go so high that they rise above long-term interest rates, an inversion of a historical norm, that means the FED has a very tight monetary policy. Because most of the volatility in the economy, in terms of recessions and expansions, can be explained as a result of FED (monetary policy) actions, this inversion logically should signal a recession.
Furthermore, because long-term interest rates just represent banks' bets on what short-term interest rates are going to average out to over time, an inverted yield curve represents a bet that the FED will have to cut interest rates in the future. This means the markets are betting that the government will decide in the future that spending is too weak and it needs to boost spending. This future decision could stem from the realization that the economy is in a recession (or heading towards one).
Reason #1: New Form of Monetary Policy Implementation
The way monetary policy works has changed, which might mean the inverted curve no longer portends a recession.
The FED’s policy of only touching the federal funds rate ended in 2008 when the federal funds rate was cut to below .25% but it seemed the economy still needed more stimulus. The FED asked Congress to do much more fiscal stimulus. It also started buying long-term bonds and long-term mortgage backed securities. The purpose of this policy action by the FED was not to change the Federal Funds Rate but to lower other interest rates more directly. By raising the price of long term bonds, the market rate of return on them fell as did long term interest rates in general.
In other words, it directly worked on modifying longer term rates. This also meant that the interpretation of long term rates as averages of expected short term rates changed. For that matter, the interpretation of the difference between long term and short term rates might also mean something different.
After a few years of a weak economy and deficit reduction, the FED finally felt confident enough to start selling its purchases of longer-term debts. After a while it started raising the Federal Funds Rate in order to return to the old way of setting interest rate policy.
When Covid-19 hit the US, the FED cut the Federal Funds Rate to near-0 and bought long-term US debt and mortgage backed securities. It also bought corporate bonds and set up direct lending facilities.
It seems that the FED may be unable to fully return to the old way of doing monetary policy. The US is in a long-term weakening of demand where more extreme actions have to be taken over time in order to keep demand high enough. Hence, a situation where the Federal Funds Rate is sustainably above 0% to a meaningful degree may be unobtainable going forward.
If the interest rate on all safe debt eventually falls very low (let's say below 1%) and the FED conducts monetary policy mainly by lending money to more and more risky financial institutions, then the US government yield curve will fail to act as a good way to predict the next recession.
Reason #2: More Important Fiscal Policies:
Changing monetary policy is not the only reason the yield curve could stop predicting recessions. A more important fiscal policy could also limit the usefulness of the yield curve.
Yield curve inversions do not predict recessions caused by fiscal policy. The recession which started at the end of WW2 was not forecasted by a yield curve. This recession was primarily caused by the fiscal policy effect of reduced military spending at the war's end. It is likely that yield curve inversions will be less predictive of recessions going forward the more influential things outside of monetary policy (like fiscal policy) become in shaping the course of the economy.
There is statistical evidence that the impact of fiscal policy on the economy is becoming more variable.
It is hard to compare the relative importance of interest rate policy and fiscal policy. However, economists have tried to roughly calculate the magnitude of the relative impacts of fiscal and monetary policy on aggregate demand. A literature review of studies on the matter conducted by Lawrence Summers finds that a 1% increase in the debt-to-GDP ratio will cancel out the effects of a roughly .04% increase in interest rates across the board. Meanwhile, it also finds that 1% increase in the deficit-to-GDP ratio will cancel out a .35% increase in interest rates. His work includes studies of European countries, who have default risk priced into interest rates their government debt and I suspect the estimates are on the high side. Additionally, it is a bit overly-simplistic to represent the stance of fiscal policy just with deficits and debts. A 1% increase in deficit-to-GDP caused by an income transfer to the wealthy will be less impactful on demand than a 1% increase caused by direct government spending.
In any case, we can adopt these high estimates of the effect of fiscal policy and see that fiscal policy has been a lot less impactful than monetary policy. The graph below shows the effect of fiscal policy using the estimates given by Larry Summers. His work allows us to look at the debt-to-GDP and deficit-to-GDP at any year and calculate the level of stimulus those debts and deficits provide in terms of % across-the board declines in interest rates. When the blue line is at -2 (for example) then the effect of the debt and deficit being where they are (as opposed to 0) is the equivalent of all interest rates being 2% lower in terms of the impact on aggregate demand. The chart shows that, at least from 1946 to 1990, the volatility in Aggregate Demand created by fiscal policy actions was rather weak. However, the effect of fiscal policy seems to have gotten more significant since then.
On top of the statistical evidence, we know that recently, in response to Covid crisis, fiscal policy has become a lot more important. We also know that increasingly traditional monetary policy is becoming unworkable due to weakening aggregate demand; so policymakers may need to put fiscal policy even more into the driver's seat of the economy.
More important fiscal policy as a result of weaker monetary policy means that we cannot rely on the yield curve to predict the next recession. For instance, if the next recession is caused by the expiration of covid relief programs, the yield curve will not predict it.