The Inverted Yield Curve and Coming Recession

In late August CNBC announced, “Yield curve inverts again on fears the Fed won’t save the economy.” (Gee, ya think?) In this blog post I’ll explain what all the fuss is about, and why the Austrians can explain the yield curve’s “predictive power” better than the Keynesians.

In the postwar era, a so-called “inverted yield curve” has been a very good indicator of a coming recession. (See these academic papers for a rigorous treatment, and for further references.) An inverted yield curve means that the yields on shorter term bonds are higher than on longer term bonds. (This is unusual, at least in the age of fiat money; the yield curve is usually upward sloping, meaning that investors insist on a higher yield if they are going to tie up their money in a longer loan period.)

As the chart indicates, you can see that shortly before the last 4 recessions, the yield on the 3-month Treasury (red line) surpassed that of the 10-year (blue line). You can also see that since late May, this particular yield curve has been inverted again, which is why many analysts are worried about an impending recession. (To avoid confusion: Economists tend to look at the 3m-10y spread, whereas many in the financial sector prefer the 2y-10y spread as the best indicator. The CNBC article linked above was referring to the 2y-10y spread, for example.)

Now Keynesians tend to explain this “predictive power” by saying: When bond investors forecast a sluggish economy, they predict that the Fed will cut short-term interest rates. So this is why moderate-term bond yields drop when investors expect a coming recession. That’s why the yield curve inverts before a recession.

There are two problems with this. First, it is basically saying, “Investors know a recession is coming, their response causes the yield curve to invert, and that’s why they can look at the yield curve and know that a recession is coming.” It’s a bit circular.

Second and more significant, look again at the chart. When the yield curve inverts before a recession, it’s not necessarily because the 10-year (blue line) collapses. Rather, it’s because the 3-month (red line) shoots up. This is most evident in the period 2006-2007, when the Fed was raising rates in an effort to cool down the housing bubble.

Notice that this lines up quite nicely with standard Austrian business cycle theory. According to the Mises-Hayek explanation of the boom-bust cycle, what happens is that the Fed and commercial banks push unbacked credit into the financial sector, pushing interest rates below their “natural” level. This sets in motion an unsustainable boom of apparent prosperity, which is actually built on quicksand. When the Fed chickens out, it slows the pace of credit expansion, which causes interest rates to rise. The entrepreneurs realize they overextended themselves, and begin to slash output and lay off workers.

To repeat, this standard Austrian story fits the yield curve pattern quite nicely. During the boom period, when the Fed is pumping in credit through monetary inflation, it is short-term rates that will be pushed down the most. So that’s why short rates are lower than long rates, and you see a “normal,” upward-sloping yield curve. Then, when the Fed slams on the brakes, it’s primarily short rates that jump up, exceeding long rates. This causes the inverted yield curve. Then the recession soon follows, because the economy has to reckon with the “malinvestments” made during the unsustainable boom.

For more details, and to see more information about the timing of the impending recession, subscribe to the Lara-Murphy Report, where we have been reporting on this issue extensively.