Even The Fed’s Cherrypicked Indicator Is Yelling Recession

Even The Fed’s Cherrypicked Indicator Is Yelling Recession
Stéphane Renevier, CFA

over 1 year ago2 mins

The relationship between bond yields is seen as one of the best ways to assess the likelihood of a recession. But while most investors look at the one set of bond yields to do just that, the Fed has conveniently tweaked the metric to give a better impression of the economy.

Let’s start at the beginning. The relationship between bond yields is reflected by a “yield curve”, which typically compares the 10-year bond yield with the 2-year yield. The former tends to be higher than the latter, which makes sense: you’d expect to earn a higher yield for holding an asset for longer, given the greater risk you won’t be repaid. But when investors are expecting a dramatic slowdown in economic growth, the reverse is true: short-term yields outpace long-term yields. This is known as the “yield curve inversion”, and it’s preceded every recession bar one.

But when the yield curve inverted earlier this year, the Fed was quick to explain it away: investors were looking at the wrong maturities. Investors should be looking at the relationship between 18-month and 3-month bond yields, which, the Fed argued, are a much more accurate reflection of short-term economic growth. And since those yields were looking as healthy as ever, the Fed reassured investors that there was no reason to worry.

Now, though, this yield curve has inverted too. You can see that in the chart above, which shows the relationship between 18-month yields and 3-month yields (orange line) turning negative. So even if we accept the Fed’s position that there wasn’t cause for concern before, there certainly is now: the inversion suggests any weakness we’ve been seeing in recent economic data is just the start. So even if you’ve been steering clear of the bond market, the message is clear: prepare for tougher times ahead.

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