(Bloomberg) — The next time a U.S. recession hits, what has traditionally been a reliable harbinger of an economic slump may end up being the dog that didn’t bark.
The shape of the U.S. yield curve — specifically, the spread between 10-year and three-month Treasury yields — is often used by economists and investors to gain insight about what’s in store for the world’s largest economy.
Typically, when yields on longer-dated debt dip below shorter-term yields, it serves as a signal that market participants believe monetary policy is overly tight, and that the central bank will be forced to cut short-term rates to stimulate the economy.
For that reason, the so-called “inverted yield curve” is considered to be a leading indicator of a recession, and has delivered few false positives over several decades.
For bears, crossing “yield curve” off the list of indicators that herald an economic downturn is, at present, a welcome development. According to JPMorgan Chase & Co., credit spreads and the decline in the S&P 500 imply a much higher probability of recession during the next 12 months than the spread between 10-year and three-month Treasury yields.
You can count Deutsche Bank AG Chief U.S. Economist Joseph LaVorgna among those who think the next U.S. recession won’t necessarily be preceded by an inverted yield curve.
“The reason we caution against using the U.S. yield curve as a leading indicator is that short rates are still extremely low,” he wrote.
LaVorgna turns to Japan as a case in point:
“Over the last two decades, the Japanese yield curve has flattened ahead of each of the last four recessions (1997 to 1999, 2000 to 2002, 2008 to 2009 and 2012). Yet in each case, it did not invert,” the economist explains. “Consequently, we believe there is a high probability that whenever the next U.S. recession occurs, the 10s-funds curve is likely to remain positive, and perhaps significantly so, at least compared to past business cycles.”
The comparison with Japan, however, falls short in some respects. Most notably, 10-year debt in Japan has never (save for one brief stretch last year) had a higher nominal yield than German bunds or U.S. treasuries of the same maturity over the time period examined by LaVorgna. Foreign private inflows are also capping how high yields can go at the longer-end of the U.S. curve, as continued quantitative easing by the Bank of Japan and European Central Bank spill over to the U.S and put downward pressure on Treasury yields.
The Federal Reserve’s massive holdings of U.S. debt is another factor that muddies the water in terms of what investors can hope to discern from the spread between short and long-term Treasury yields.
Mark Dow, founder of Dow Global Advisors, suggests that, as a result, a flattening of the curve or even an outright inversion might not be harbingers of recession.
“The Fed involvement in the long end of the curve makes it not very useful, in my humble opinion, to try and extract much economic information from the curve shape,” said Dow. “Changes in the curve shape tell you something about changes in psychology, but the level of slope probably doesn’t tell you too much — even [if] it were inverted.”