“Mr. Chairman, that [the yield curve] used to be one of the most accurate measures we had to indicate when a recession was about to occur and when a recovery was about to occur. It has lost its capability of doing so in recent years. The markets have become far more complex, and the simple relationships that that yield curve slope indicated no longer work... The effectiveness of that relationship to where the economy is going has virtually disappeared, and while it has significant financial impacts, it’s no longer useful as a leading indicator to the extent that it was.”—Fed Chairman Alan Greenspan, November 3, 2005, Testimony to the Joint Economic Committee
The treasury yield curve continues to garner plenty of attention these days. Looking at the financial news it almost feels as though they’d have a “countdown to inversion” clock on the screens, if only they knew exactly when it was due to happen. Yet there is also an ongoing debate in the market and amongst the central bankers as to what such an inversion (were it to happen) actually means. Given that we are now only 26 basis points away from a perfectly flat curve, coupled with the fact that at its last FOMC meeting the Fed indicated that the median view on the committee was for two more 25-basis-point rate increases this year and four more after that, the potential for such an inversion has clearly increased. Certainly this is a question Chairman Powell will be asked next week as he sits in front of Congress for his biannual Monetary Policy Report to Congress, in much the same way Chairman Greenspan was asked the same question back in 2005. As such, in the this week’s Economics Weekly, we discuss the yield curve and what an inversion might imply for Fed policy and the economy.
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Richard de Chazal, CFA is a London-based macroeconomist covering the U.S. economy and financial markets.