After the yield curve’s most widely monitored measure inverted in March, members of the Federal Open Market Committee were quick to play down the pessimistic outlook offered by the bond-market recession indicator.
The litany of dismissive remarks comes amid concerns from market participants that an economic downturn would force the central bank’s hands, and push it to cut interest rates to end the current hiking cycle. In recent weeks, members of the Federal Open Market Committee including Mary Daly, Robert Kaplan and Charles Evans have all publicly looked past the economic significance of the inversion, with some citing the fall in the terminal interest rate for the subdued level in long-dated bond yields.
The 10-year Treasury yield TMUBMUSD10Y, +3.91% fell below the three-month bill TMUBMUSD03M, -0.33% on March 22, its first such inversion since 20017. An inversion by that measure has signalled the nine last recessions since 1955.
See: Why the world’s biggest bond investor is dismissing the recession warning of the yield curve
With economic data still solid, there’s still reason to think the brief inversion may not flash warnings for the U.S. economy this time around, but U.S. central bankers would do well to remind themselves of times when the Fed ignored the oracular powers of the bond-market indicator. Here are a few of those famous last words:
Before the 1990-’91 recession
Before the 1990s, the Fed interpreted the yield-curve inversion as a reflection of subdued inflationary pressures, allowing long-dated yields to drift closer to their shorter-term peers. This lowered the threshold for an inversion, diluting its predictive abilities.
Thinking that higher prices were ultimately the trigger for monetary tightening, and thus recessions, the muted inflation pressures throughout the 1980s suggested to central bank policymakers that it had yet to reach the occasion where it was pushing policy into restrictive territory.
“The yield curve either in the United States or elsewhere has not been a reliable indicator of future inflation. Indeed, the evidence seems to cut the other way. And if it has not been a reliable indicator of future inflation and most recessions are inflation-induced, I am not prepared to bet the mortgage on the signals that the yield curve are giving off right now,” said former New York Fed President Gerald Corrigan in February 1989.
Before implosion of the dot-com bubble
This time the Fed and Treasury officials attributed the inversion and the fall in long-dated yields to the balanced budgets, and the occasional fiscal surplus, under President Bill Clinton’s administration. In their minds, the fall in bond supply relative to demand had artificially pushed bond prices higher, and yields lower, making a yield-curve inversion that much easier to achieve.
“I think the changed supply outlook for Treasuries has introduced a fair amount of noise into the Treasury yield curve,” from Peter Fisher, manager of the Fed’s System Open Market Account, at the March 2000 Fed meeting.
Before the 2007-’09 recession
Former Fed Chairman Ben Bernanke in a speech at the Economic Club of New York in 2006 said bond-buying from foreign investors may have been responsible for pushing long-dated Treasury yields lower as part of his “savings glut” thesis. That is, high savings rates across the world were being funneled into U.S. assets, reducing the so-called term premium, or the extra yield investors demanded for buying long-dated bonds to compensate for the risk of interest rates not moving as expected.
“First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates — in nominal and real terms — are relatively low by historical standards. Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative,” said Bernanke.
And now
Echoing the remarks of Bernanke, New York Fed President John Williams in 2018 said quantitative easing by major central banks, including the European Central Bank and the Bank of Japan, may have flattened the yield curve’s slope, narrowing the spread between short-dated and long-dated yields.
“In thinking about the historical experience of the yield curve, we do have to be cautious about applying it to this current situation. We and other central banks around the world have taken aggressive actions to buy lots of long-term assets, which has arguably pushed down the term premium, or the yield, on 10-year Treasurys,” said Williams.
Read: Fed’s Brainard says an inverted yield curve won’t get in way of rate hikes
Providing critical information for the U.S. trading day. Subscribe to MarketWatch's free Need to Know newsletter. Sign up here.