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Enterprising Investor
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21 July 2023


THE PREDICTIVE POWER OF THE YIELD CURVE

By Joshua J. Myers, CFA
Posted In: Drivers of Value, Economics, Fixed Income, Future States, History &
Geopolitics, Risk Management

> “[O]ur mind is strongly biased toward causal explanations and does not deal
> well with ‘mere statistics.'” — Daniel Kahneman, Thinking, Fast and Slow

The predictive power of the yield curve is a widely accepted causal narrative.
But the history of the yield curve shows that the causal correlation between
long and short rates is actually quite weak. While long and short rates tend to
move in the same direction, they do so at varying rates.



The debut of the Federal Reserve System in 1914 and the advent of modern central
bank orthodoxy amid the Great Inflation of the late 1960s to early 1980s
contributed to a divergence in how the market sets long and short rates. The
yield curve’s predictive accuracy was decidedly mixed in the first half of the
20th century but was much more reliable in the second half — a shift that aligns
with how the the US Federal Reserve has evolved over the years. 

During the 19th century and the first three decades of the 20th, yields for
four- to six-month commercial paper were higher on average than those of prime
long-term bonds. As the US Civil War gave way to peace and deflation, interest
rate levels exhibited a downward trend. But towards the turn of the century,
gold discoveries increased the money supply and sent rates higher. During this
period, the market set interest rates based primarily on the supply and demand
of loanable funds. The low interest rates of the post–Civil War era did not
prevent eight different NBER recessions between 1868 and 1900.

But higher rates from 1900 to 1920 didn’t exert much of an influence over the
economy either, with six different NBER recessions over the 20 years. A
persistently inverted yield curve may have contributed to the high frequency of
recession. After all, a negatively sloped interest rate term structure
disincentivizes long-term investment.

Only after 1930 did positive yield curves become more regular. The 1929 stock
market crash, the resulting shift toward greater economic planning by the state,
and the integration of Keynesian economic policies later in the 1930s certainly
shifted the slope of the yield curve. As short rates came onto economic
policymakers’ radar, they introduced a new causal force that broke the link
between short and long rates.

With the markets free to set long-term rates, the views of policymakers and the
market on the state of the economy diverged. The Fed’s open market operations
are, by their nature, countercyclical and lag the real economy. The market, on
the other hand, is a forward-looking voting machine that represents the
collective wisdom of the crowd. When the market thinks the Fed is too hawkish,
long rates fall below short rates. When it perceives the Fed as too dovish, long
rates rise well above their shorter counterparts.



Market prices are the best indication we have of future market outcomes. Why?
Because of the potential rewards available. If the future is in anyway knowable,
prices in a free market are the most effective crystal ball: Resources will be
directed to take advantage of any mispricings. Financiers in earlier eras would
not recognize a connection between long-term and short-term rates. They saw
short-term lending as primarily concerned with the return of principal and
long-term lending on return on principal. But the combination of Keynesian
economic policies and the market’s discounting mechanism made the yield curve
the predictive tool that it is today.

But it needs to be deployed with caution. It is not just the slope of the curve
that matters but how it develops and how long the curve is inverted.

--------------------------------------------------------------------------------

Cumulative Days of Yield Curve Inversion

Source: Federal Reserve Bank of St. Louis, NBER

--------------------------------------------------------------------------------

The yield curve has inverted from positive to negative 76 different times since
February 1977 according to the preceding chart — sometimes for months at a time,
at other times for just a day — but there have only been six recessions. So,
inversion alone is hardly an accurate oracle. Only when the market and the Fed
veer apart for an extended time period, when the market expects significantly
lower growth than the Fed, does the market’s recession expectations tend to play
out. Given the efficiency of the market voting machine, this should hardly come
as a surprise.

The yield curve is a popular recession indicator for good reason. But we need
more proof of its efficacy, particularly when the signals suggest that Fed
policy is too loose.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.

--------------------------------------------------------------------------------

All posts are the opinion of the author. As such, they should not be construed
as investment advice, nor do the opinions expressed necessarily reflect the
views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ ardasavasciogullari

--------------------------------------------------------------------------------

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Tags: bonds, central banking, fixed income, Investment Products and Asset
Classes, risk management, US Federal Reserve, US Treasuries, Yield Curve

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About the Author(s)

JOSHUA J. MYERS, CFA

After a successful 20-plus year investing career, Joshua J. Myers, CFA, launched
Cedars Hill Group to bring large market expertise to broader audiences. He
primarily serves as an outsourced CIO/CFO for family offices, RIAs, and
small-to-medium sized businesses. He started as an assistant trader at
Susquehanna Investment Group during the Russian default and LTCM failure in
1998. Afterwards, he was head of fixed Iicome at Penn Mutual Life Insurance
during the global financial crisis (GFC). He traded distressed CMBS securities
in the aftermath of the GFC at Cantor Fitzgerald and most recently was chair of
the board for an oil production company during the COVID pandemic. He is a
lifelong student of financial markets and writes about current events with a
focus on the art of decision making and cognitive psychology.

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