Saturday, July 12, 2014

The Best Recession Indicator is Broken?

So, what do you know about the yield curve?

I just read an interesting article by the Acting Man about "The Yield Curve and Recessions". As the title suggests, when a yield curve inversion happens, usually recessions will occur.

A yield curve inversion happens when the interest rates for the shorter duration bonds becomes higher than the interest rates for the longer duration bonds.

I think this video sums it up quite well. I wrote about it in a previous post too.

Here are some quick links to yield curve graphs that she mentioned in the video.

I just want to pull out and highlight a particular thing that she said, which I now find a bit strange after reading the Acting Man's article.

4.02: "Where are we are right now, we are actually on a very steep curve. So there is no threat to the stock market right now from the bond market."

Really now? We are quite safe? Well, as the Acting Man points out, maybe not so. Look at this chart from Japan.

With weird and unconventional monetary policies, you can see how broken this traditional indicator is. In case you're wondering, before the Fed in the US decided to engage in ZIRP, the yield curve inversion predicted a recession 7 out of 7 times. We might as well take it is a given if it's so damn accurate!

Anyway, my whole point of this post is this: With the Fed keeping short term interest rates near zero through policy, the bond market is not a free market and it will not give us the usual recession signal. As shown by Japan, you do NOT need a yield curve inversion to have a recession. But if you do have one, well, you're still probably going to have a recession.

Stay safe out there, things are looking messy! Return of capital is more important than return on capital!

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