The economist who discovered the yield curve's predictive powers says he's getting worried

  • Arturo Estrella and his former Fed colleagues used to watch the relationship between the 10-year Treasury and the 3-month bill.
  • A lot of people have been focused lately on the difference in rates between the 10-year and 2-year Treasurys.
  • Estrella says the flattening of the curve that he watches has been increasingly worrisome.
Bond traders at CME Group
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I just spoke with Arturo Estrella, the now-retired professor of economics at Rensselaer Polytechnic Institute and former New York Federal Reserve economist who is best-known for his study of the predictive power of the yield curve.

Once again, he said that the curve he and his colleagues studied while at the Fed involved the relationship between the rates on the 10-year Treasury note and the 3-month Treasury bill. When those rates move closer to each other, the curve is said to be flattening, and when the shorter-term Treasury has a higher rate than the 10-year, the curve is said to be inverted.

Lately a lot of people have focused on the difference between the rates on the 10-year and 2-year Treasurys, which in Estrella's view is the wrong curve to be watching.

Having said that, he finds the flattening of the curve that he watches to be increasingly worrisome.

When that curve flattens or inverts, a recession is anywhere from nine to 15 months away, with the average lead time of one year.

Before Tuesday, the last time I spoke to Estrella the difference between the 10-year and 3-month Treasurys was around 90 percentage points, or nine-tenths of one percent.

As of Tuesday, however, it had narrowed even more noticeably, down to under one-half percentage point. That leads Estrella to say he is more nervous about the yield curve's message now than he was several months ago.

If the Fed continues to raise short-term rates beyond December, Estrella says that an inversion of this spread would be virtually guaranteed. And that is a very bad omen for the economy.

He agreed with my assessment that the stock market declines in tandem with, or just after the curve inverts, but before a recession actually begins.

That process may be playing out right now before our very eyes, assuming the Fed keeps hiking rates and economic indicators continue to weaken.

Most assuredly, the uncertainties surrounding the on-going trade war with China are of concern to him, as are indicators of global economic weakness.

All Treasury curves of note have flattened considerably, one has even inverted. That has sparked a lot of discussion about the implications for both Main Street and Wall Street.

There is no way to take our eyes off this ball for weeks to come. It could be strike three for the 2019 economy.