Part One: Look Past the Yield Curve
October 2019

To Weather a Recession, Look Past Yield Curves

According to the National Bureau of Economic Research, a recession is:

… a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale and retail sales.1

That definition probably doesn’t surprise anyone. What might surprise you is that inverted yield curves don’t forecast a recession, they only forecast conditions that make a recession more likely. But before explaining this difference, let’s talk about what causes interest rates to rise, fall or invert.

To answer this, we must go waaaaay back in time (Wall Street asks, “Further back than yesterday?”) to the year 1957. That was the year Milton Friedman introduced us to The Permanent Income Hypothesis in his seminal research, “A Theory of the Consumption Function.” 2

This hypothesis states that an individual’s spending today depends not only on their current income, but also on the likely path of their future income. For example, if someone expects higher income in the future, then they will consume more today. And we can actually observe this happen in near real-time by looking at data such-as savings and spending rates (such-as credit card balances, auto purchases, etc.).

This hypothesis also applies to corporate America. A company’s current spending is predicated on the likely path of its future income. And like individuals, we can see in near real-time whether corporate America is saving or spending its money by looking at its capital allocation decisions and its income statements and balance sheets.

Collectively, when the U.S. population or corporate America is feeling confident about its prospects, spending will increase and savings will decrease. This combination – increased spending and decreased savings – is what creates upward pressure on real interest rates, which is manifested in yield spreads.

For example, a high 1-year yield indicates the community expects high growth over the next 1-year; the same is true for a 10-year yield. Further, if the difference between the 10-year yield and 1-year yield is positive, then growth is expected to accelerate. Conversely, if the difference between the 10-year yield and 1-year yield is negative – or inverted – then growth is expected to decelerate. 3

News Flash! That’s the reason an inverted yield curve doesn’t forecast a recession!

Did you miss the reason? It’s easy to miss, so re-read the last sentence of the previous paragraph.

An inverted yield curve only forecasts a deceleration in growth, not an actual recession. And we know that industries are always growing and contracting, yet this hardly causes a recession.

So then, what causes a recession? Stay tuned for Part Two!

1 The National Bureau of Economic Research.
2 Friedman, M. The Permanent Income Hypothesis. “A Theory of the Consumption Function”. Princeton University Press. 1957.
3 The 1-year and 2-year Treasury notes are highly correlated; when the 10-year and 2-year spread has inverted, so has the 10-year and 1-year.