October 17, 2018 glacierinvest

Great letter from the SF Fed on the flattening yield curve as a recession indicator.

The Slope of the Yield Curve and the Near-Term Outlook

“Using both a descriptive approach and evidence from a dynamic model of Treasury yields, I find that the risk of a recession within the next year is only slightly higher than the risk of being in a recession in any random month. Hence, at this time, it may be warranted to not put too much weight on the signal from the yield curve flattening, particularly in light of structural factors that may be weighing down long-term yields and causing the signal to be less reliable than in the past.”

I believe the structural factors are an important element of the current yield curve dynamic that may be underappreciated. Isolating the cyclical or transitory contributors to the current yield curve from the secular or longer-term contributors is a critical exercise to go through. It may be that the slope of the yield curve is flatter than usual for years to come as a result of structural factors. However, Central Bank balance sheet shrinkage, higher government deficits for the foreseeable future and higher prices via trade conflicts seem like they will push longer-term rates higher from here, likely resulting in a steepening yield curve.