The Market’s Favorite Recession Signal Probably Has It Wrong - WSJ 4/30/20, 1:15 PM

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MARKETS | STREETWISE

The Market’s Favorite Recession Signal

Probably Has It Wrong
Fears over the coronavirus outbreak have pushed the yield curve negative, but this may reflect
something more benign

By James

Mackintosh
Updated Feb. 4, 2020 5:43 pm ET

The market’s most-popular recession warning is flashing red again as fears

about the economic impact of China’s coronavirus outbreak prompt a big
drop in Treasury yields.

Yet the warning—a drop in the 10-year Treasury yield below the three-
month bill, known as an inverted yield curve—is signaling something much
more benign: the expectation of Federal Reserve support later this year.

The inversion was also small enough that a bout of optimism leading to
higher bond yields saw the 10-year yield edge above the three-month again
on Tuesday. The 10-year yield’s rise to 1.603% reversed a recent downward
trend, while the three-month yield stood at 1.571%.

In fact, the yield curve is increasingly likely to miss the next recession
anyway, because the Fed is already so close to zero.

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The 10-year yield has fallen below the three-month bill yield ahead of every
recession since the 1960s. It has also sent two false alarms, in 1966 and
briefly in 1998. Economists disagree about quite why it should predict
recessions, but since no other method of predicting recessions has proved
as reliable, investors tend to put a lot of weight on it.

The inversion which began last week looks more like the 1998 exception
than it does the correct warnings, however. Prerecession yield curve
inversions in the past occurred because investors believed that interest
rates were temporarily too high as the Fed tried to slow the economy and
reduce inflation.

That isn’t the case today and wasn’t in 1998. Far from trying to slow the
economy, Fed Chairman Jerome Powell has been clear that the central bank
stands ready to help. The yield curve has inverted not because investors
think the Fed is in danger of raising rates too far, but because they are
anticipating that rates will be cut even further. Rather than inverting

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The Market’s Favorite Recession Signal Probably Has It Wrong - WSJ 4/30/20, 1:15 PM

because short-term bill yields went up, the curve has inverted because long-
term bond yields have come down.

Federal-funds futures are pricing in at least one rate cut, and close to a 50%
chance of two or more cuts this year. The three-month yield doesn’t reflect
these expected cuts, but longer-term yields do, so long-run yields are below
the three-month yield.

So far, so positive (assuming the Fed doesn’t derail markets by unexpectedly

turning hawkish). Rather than pricing in a recession, investors are pricing
in slower growth partially offset by cheaper money.

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Far from trying to slow the economy, Fed Chairman Jerome Powell has been
clear that the central bank stands ready to help.
PHOTO: SAMUEL CORUM/GETTY IMAGES

Unlike 1998, however, the Fed faces a new issue: Rates are getting
uncomfortably close to zero once again. Futures put more than a one-in-six
chance of rates below 1% by the end of the year. This appears to factor in the
risk that government and consumer fears about the coronavirus infection
prompt a sharp economic slowdown.

The Fed will be unable to respond to the next recession the way it did in
prior downturns when it cut rates at least 5 percentage points. With rates
currently at 1.5%-1.75%, it would have to rely on alternatives such as bond-
buying and forward guidance, which are less-well tested as recession-
busting tools.

Japan offers an important lesson from its two decades of near-zero rates:
The yield curve offers no recession warning when the central bank is
running low on ammunition.

Japan’s experience shows that when rates are on the floor, it is hard for the
yield curve to invert. After the Bank of Japan slashed interest rates in the
early 1990s, the yield curve failed to warn of all four (or six, depending on
definition) subsequent recessions. Bond yields can approach zero, but
unless a central bank takes rates negative it is very hard for bond yields to
go lower, even when recessions are anticipated. Japan’s yield curve
eventually inverted when rates went negative in 2016, but it was a false

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The Market’s Favorite Recession Signal Probably Has It Wrong - WSJ 4/30/20, 1:15 PM

alarm and no recession followed.

So there is good news and bad news from the U.S. yield curve. This inversion
is primarily technical, indicating that a dovish Fed is expected to offer
support to the economy and markets. But as the Fed is driven closer to zero,
the next recession might come without the handy warning of an inversion.

Write to James Mackintosh at James.Mackintosh@wsj.com

Copyright © 2020 Dow Jones & Company, Inc. All Rights Reserved

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