Economic Curves and U-Turns - August 27, 2019
“Impossible to Guarantee Future Results”
The US yield curve is in the news once again as the yield on the 10-year continues to sit below the 2-year. While it would be easy to blame Trump’s flamethrower-esque tweets or underwhelming remarks from Powell at last week’s Jackson Hole conference, the inversion of the 2s-10s occurred before either man stood on his soapbox. As discussed in this article from CNBC, 2s-10s inverted on Thursday, which was “the third time the recession indicator has been triggered” in just over a week.
While the 2s-10s curve may get a lot of the press, it is the 10-year to 3-month spread that is seen as the better indicator of recession and is used in the New York Fed’s Recession Probability predictions. Underlying the Fed’s model are two papers, set a decade apart, that analyze the ability of the yield curve to predict recessions. In their 1996 paper, Arturo Estrella and co-author Frederic Mishkin found that “the yield curve spread can have a useful role in macroeconomic prediction, particularly with longer lead times”. In their 2006 paper, Estrella and co-author Mary Turbin, took the yield curve’s predictive power as a given and analyzed how to best “construct” and “interpret” yield curve-based models. They find the spread between “ten-year and three-month bond-equivalent rates” to be “a simple and historically reliable benchmark.” However, they find that it is “persistent negative signals” (emphasis our own) that are “reliable predictors”. Finally, they conclude by reminding readers that “however accurate past signals have been, it is impossible to guarantee future results”. The NY Fed has a useful FAQ page for those looking for more about the 10year-3month spread and who may be worried as the 10y-3m spread is set to record its third consecutive month of inversion.
While Keynes is famously misquoted as saying “When the facts change, I change my mind”, it can be surprising when there are opinion U-turns among policymakers, politicians, and academics. By this metric, the past week has been full of surprises. Last week, Larry Summers brought into question the efficacy of forward guidance and QE in a tweetstorm and subsequent article. Summers warns there are reasons to believe “the capacity of lower interest rates to stimulate the economy has been attenuated – or even gone into reverse”. Perhaps he has been reading Epsilon Theory. Another surprise was a recent article from the San Francisco Fed questioning the heart of the BoJ’s current policy rate. In “Negative Interest Rates and Inflation Expectations in Japan” Jens Christensen and Mark Spiegel reference a larger research paper of their own where they find that, rather than view negative rates as a good thing, “the market appeared to treat negative rates as bad news” and rather than boost inflation expectations, the move to negative rates “decreased, rather than increased, immediate and medium-term expected inflation”. The authors do take the time to suggest their work belongs in the garbage by reminding readers “it is possible that the decline in medium- and long-term inflation expectations in the data might have been even steeper if the BoJ had not moved into negative policy rates”. Tough to prove a negative and “Einmal ist keinmal”? Finally, while most Fed speakers have been quick to assert that they are politically independent, ex-Fed Dudley made a surprising break from the fold today in an Op-Ed in Bloomberg. Dudley argues that not only should the Fed not “bail out” an administration that makes “bad choices on trade policy” (he points to moral hazard without a note of introspection) but goes as far as to assert that “the election itself falls within the Fed’s purview”. While Dudley is not currently on the FOMC nor at a regional branch, we will see if his comments spark another Fed-bashing tweet from President Trump.