Yield Curve – Return to Normal

Remember September of this year? It was only 2 months ago that the yield curve partially inverted, which caused some investors and talking heads in the financial media to aver that this is strong evidence that the US economy is heading into a recession soon because inverted yield curves have presaged a recession in the past.

Un-Inversion

Now, as I write this, the yield curve is back to its normal upward-sloping arc. Whereas in September, at its widest diversion, the 3 Month US Treasury was in the 1.9%-range whilst the 10 Year Note was below 1.5%, now it is the 3 Month with the lower yield at about 1.6% and the 10 Year at about 1.9% (Source: Treasury.gov). Nearer-term rates are lower than longer-term rates almost entirely across the spectrum. Am I hearing from those same pundits that the recession risk has been averted? So far, crickets.

IMO

What do I think? I didn’t believe that the inverted yield curve in September was signaling a recession. I thought that it was signaling an overbought situation at the long end of the curve. I wrote that there were many other factors at play that signaled no recession, such as low inflation, high employment/low unemployment, and sufficient cash in the financial system. As for the return to a normal, upward-sloping curve, I don’t think that necessarily signals that there is any less probability of a recession. I think it does mean that the predictive power of the shape of the yield curve is not that robust. Then there is the next thing to ponder: Quantitative trading algorithms are founded upon such probabilities as “inverted yield curve likely equals upcoming recession”. Algos are based on the probability of something that has happened in the past will happen again. Any algo that traded in September that there will be a recession due to an inverted yield curve is likely underwater now. Algos work until they don’t. If you are looking at investing with someone who has an algo strategy, caveat emptor. Higher than 50% probability doesn’t equal certainty.

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