Why The Yield Curve May Not Matter

The yield curve has become a hot topic again in the financial press because the most widely followed 10-2 spread finally inverted. There is too much analysis that just reviews what happens on average each cycle and not enough research into what is likely to happen based on the unique factors in this expansion.

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Even if data goes back a few decades, if there are only a few cycles to look at, that’s not a large sample size. We all know that the 10-2 curve has a good track record of predicting recessions, that stocks usually rally in the period after the inversion and before the recession, and that it takes about 21 months on average for there to be a recession after the inversion (assuming the indicator is correct).

Why The Yield Curve May Not Matter

It’s common sense that if everyone is looking at an indicator, it will lose the ability to generate alpha. That’s how events get priced in before they occur. It might even lose predictive value. On the other hand, let’s not forget that if everyone fears a negative catalyst, even if the indicator doesn’t lead to trouble, the fear of a negative impact itself can hurt the economy and markets.

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The chart above shows an explanation as to why the yield curve won’t predict a recession in this cycle. It compares the net increase in household liabilities (lagged 1 year) as a percentage of GDP with the 10 year 3 month spread (the yield curve). The difference between this cycle and every other cycle is US households haven’t catalyzed domestic or global growth. Therefore, the yield curve may not matter. Some say that the next recession won’t be bad because US households have deleveraged this cycle. Others say, that’s not the reason why the next recession will be shallow; it’s the reason why there won’t be a recession soon. Recessions are about leverage and if you don’t have leverage, the yield curve isn’t important.

Debt As A Percentage Of GDP

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