Submitted by Taps Coogan on the 6th of December 2018 to The Sounding Line.

Headlines have been reporting that the US yield curve has inverted for the first time since 2007, drawing parallels to the eve of the Housing Crisis and stoking fears of a looming recession based on the high reliability of yield curve inversions in predicting recessions.

In reality, only one part of the yield curve inverted, not the entire yield curve, and the part that just inverted (the difference between the yield on a 5-Year treasury versus the 3-Year) is not the part of the yield curve that investors typically rely on for forecasting recessions (such as the 10-Year vs 1-Year). That is because the 5-Year vs 3-Year spread has issued two false alarms since World War II, one in 1965 and again in 1998. In those cases, the 5-Year vs 3-Year inverted and then uninverted when recession was still several years away. The preferred parts of the overall yield curve, such as the 10-Year vs 1-Year, tend to invert with slightly less lead time before the start of a recession and did not issue a false alarm in 1998, though they did in 1965. Like the 5-Year vs 3-year, the 10-Year vs 1-Year has also inverted before every recession since World War II, but with one fewer false alarm. The most reliable recession indicator is when most of the yield curve inverts, not when just one part inverts. So while the 5-Year vs 3-Year spread is a decent recession indicator, it is worth keeping in mind that the best indicators of a recession have not yet been triggered.

Furthermore, despite the headlines claiming that the 5-Year to 3-Year has inverted for the first time since 2007, a more accurate statement would be that it has inverted for the first time since December 2005. During the last economic cycle, the 5-Year vs 3-Year first inverted in 2005, almost exactly two years before the start of the Great Recession. It remained inverted until late 2007, when it uninverted. In other words, it started warning of recession five years into a seven year economic cycle.

A question of timing:

The 10-Year to 1-Year spread has inverted, on a median basis, 12 months before the start of a recession, though it has been as much as 24 and as few as eight months early.

The US has endured 42 recessions and five depressions in its history with the average business cycle lasting barely five years. In the 73 years since World War II, the US has endured 12 recessions with an average time between recessions of barely six years. The truth is that the US economy is always headed for a recession. It is simply a question of when. With a few notable exceptions, including the last recession, recessions are healthy events that purge the economy of bad businesses and debt, and keep everyone disciplined.

I would venture to guess that the majority of economists and investors already expected the next recession to arrive within the next two years, even before the recent yield curve inversion. The inversion of the 5-Year vs 3-Year yield curve makes it all the more likely.

The goal of policy makers and central banks should not be to futilely try to avoid recessions but ensure that the system can weather them without incurring structural damage, a philosophy which is totally alien in today’s hyper fragile world. After all, a recession has been less than two years away nearly half of the time throughout American history. Today is likely one of those times. The recent yield curve inversion tells us nothing more.

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