Replace Yield Curve as a Recession Predictor? The Fed Considers an Alternative

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How good are the yields on government bonds at predicting recessions?

If history is any indicator, the answer is very good. But with the economy strengthening, not weakening, some question whether looking at the yields on an array of government bonds is an effective forecasting tool. That includes the Federal Reserve. Minutes of the Fed’s June policy meeting, released on Thursday, revealed that the central bank considered an alternative approach to avoid some of the shortcomings of using bond yields.

The bond market indicator in question is the yield curve, which tracks the yields on Treasury securities that are repaid after different periods. The yields on the Treasuries that are repaid in two years are usually lower than those that are repaid, or “mature,” in 10. But sometimes, as is now the case, the difference between the yields on two-year and 10-year Treasuries narrows. When that happens, the yield is said to be flattening. This week, the spread between the two bonds was only 0.3 percentage points.

But the most alarming signal is sent when the yield curve “inverts.” That is when the yields on two-year Treasuries are higher than those on 10-year Treasuries. When that has happened in the past, recessions have soon followed.

But changes in the bond market and economy may have made the yield curve a less useful predictor. The Fed and other central banks bought huge amounts of government securities after the financial crisis, which raised their prices and reduced their yields. Those purchases may still be holding down yields. In addition, investors appear to believe that there is less risk of inflation in the global economy these days, which makes Treasuries more appealing. At the same time, the Fed has been raising short-term interest rates, and is expected to keep doing so through at least next year.

Fed policymakers can’t ignore the yield curve when setting monetary policy because of its past predictive power. At the same time, they don’t want to overreact to something that may have less relevance. So it should come as little surprise that the potential limitations of the yield curve were a topic at the Fed’s meeting last month.

Members of the central bank’s staff gave a presentation in which they used readings from another market to predict the likelihood of a recession, according to the minutes. They looked at the current interest rate in the federal funds market, in which banks borrow from and lend to each other overnight, and compared that with the fed funds rates predicted in the futures markets. The minutes said: “The staff noted that this measure may be less affected by many of the factors that have contributed to the flattening of the yield curve.”

But this exercise may be flawed, one analyst said. The futures market’s forecast for fed funds rates may be strongly influenced by the Fed’s own guidance for that rate. “The Fed is analyzing its own footprints,” said Jim Vogel, a debt markets strategist at FTN Financial.

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