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Don’t Count on the Yield Curve for Recession Warning

Don’t Count on the Yield Curve for Recession Warning

Scott Krisiloff at Avondale Asset Management thinks we're likely to enter a recession some time during the next four years. But he doesn't think one is imminent.

I hope he's right but I can't endorse his reasoning:

"A more time tested recession indicator is the slope of the yield curve—when the spread between 2 year and 10 year Treasurys is inverted recession normally follows. In a zero interest rate environment the yield curve may have lost some of its informational content, but it's been a great cyclical indicator for a long time and it's grounded in sound economic logic, so it shouldn't be totally ignored. Today, even though the curve has flattened since '09 it is still not at or near the zero threshold. When recession is imminent I'm still on the lookout for the yield curve to go completely flat or invert even in this environment."

Traditionally, the yield curve was an excellent warning signal about recessions. It threw out a false alarm every now and again, but it never failed to warn when an actual recession was imminent.

(Read more: Why US Economy May Be Headed for Another Recession)

Unfortunately, that mechanism has probably broken down now. The reason the yield curve worked was because of a complex set of interactions between traders and the Federal Reserve.

The Federal Reserve typically reacts to recessions by lowering interest rate targets. It brings down short-term rates, which in turn lowers longer-term rates. Traders understand this and when they think the Fed will lower rates—that is, when they think a recession is coming—they try to buy up long-term bonds at the higher yields available before the Fed acts. That is, they are trying to front-run the policy change.

This is the basic dynamic that explains why a yield curve can invert. It's not that traders just want less reward for longer term paper—it's that they are trying to lock-in yields before rates get cut.

When you are at the zero bound, however, this process doesn't work. The Fed has run out of room to lower rates by very much, so there is no need to front run the Fed by buying long term bonds. There's no high rate for Treasuries available to lock in before a rate cut.

This means that we probably won't get a warning from the yield curve before the next recession. In fact, this is precisely what has befallen Japan. It's had three recessions since the mid-'90s—not one of which was preceded by a yield-curve inversion.

I don't know if we'll wind up in a recession next year. But I do expect that we won't get any warning from the yield curve.

- by CNBC Senior Editor John Carney

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