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Opinion: What the yield curve is saying about the economy

MarketWatch logo MarketWatch 12/21/2018 Mark Hulbert

Editor's note: The opinions in this article are the author's, as published by our content partner, and do not necessarily represent the views of MSN or Microsoft.

“The yield curve has inverted! The yield curve has inverted!”

That’s Wall Street latest installment of Chicken Little’s “the sky is falling.” And the cry certainly has gotten investors’ attention, since every “knows” that an inverted yield curve is a reliable predictor of recessions.

This undoubtedly playing a role in the stock market’s dismal performance so far this week. Since the yield curve (by at least some definitions) became inverted at the beginning of December, the Dow Jones Industrial Average (DJIA)  has fallen 10.6% and the S&P 500 (SPX)  has fallen 10.7%.

But just as the world didn’t come to an end after Henny Penny’s warning that the sky is falling, it’s not at all clear that the current shape of the yield curve spells doom.

Related video: Shape of Treasury Yield Curve Is Meaningless, Barry Knapp Says (provided by Bloomberg)

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The yield curve, of course, is the difference between short- and long-term interest rates. In a “normal” situation, the latter is higher than the former. On occasion, however, this reverses, or “inverts.”

It’s important right off the bat to emphasize that it’s not even clear that the current yield curve is inverted in the first place. When relying on one of the most widely-used definitions of the yield curve, in fact, it is not inverted: The yield difference between the 10-year note and 90-day bill, for example, is currently positive rather than inverted. It’s only when focusing on the difference between the 3-year and 5-year that the yield curve becomes inverted, and even then only by a basis point or two.

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In any case, the probability of a recession doesn’t grow to significant levels until the yield curve becomes substantially more inverted than even the 3-year-versus-5-year curve suggests. We know this because of a famous econometric model constructed two decades ago by Arturo Estrella, currently an economics professor at Rensselaer Polytechnic and, from 1996 through 2008, senior vice president of the New York Federal Reserve Bank’s Research and Statistics Group, and Frederic Mishkin, a Columbia University professor who was a member of the Federal Reserve’s Board of Governors from 2006 to 2008.

Read:Even a growing economy can be mauled by a bear market in stocks

According to their model, the probability of a recession currently is below 20%. (See accompanying chart.) Lest you think that is a disturbingly high probability, you should know that the U.S. economy since 1860 has been in a recession 30% of the time. That means that, assuming the future is like the past and on the assumption of randomness, there is a 30% chance of a recession beginning at any given time.

In other words, the probability of a recession right now because of the shape of the yield curve is actually less than what you’d predict based on random chance.

This isn’t to say that there aren’t plenty of other things to worry about right now. There no doubt are, just as there always is.

But if you’ve become more worried this week because of doom-and-gloom analyses of the yield curve, perhaps you now can sleep more easily.

For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratingscom.

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