The Yield Curve
John Mauldin
The Yield Curve, Part 8
The Most Accurate Predictor of Recessions
Estimated Recession Probabilities
The 10 Year - 30 Year Connection
Some Conclusions
2006 Forecast, London and Happy New Year!
The level of attention to the recent and mild inversion of the yield curve has
bordered on hysteria in the media. Does it portend a recession? Or is, as Ethan
Harris, the chief economist of Lehman Brothers suggests, the bond market simply
on drugs? This week we pause in our series on trade deficits to look at the real
meaning of the yield curve and what it does and, just as importantly, what it
does not mean. I give you a basic primer on the yield curve, as well as links to
more information than you ever wanted so you can read morefor yourself.
But first, thanks to all those who purchased a copy of Just One Thing this year.
My editor tells me sales are doing very well, and another publisher has picked
up the Chinese and Korean language rights. Thanks to a lot of word of mouth,
like this note from Paul Howard:
"Just One Thing is a fantastic book! Thank you for putting it together. I read
100 pages of it Christmas Day - which is no small feat with my two-month old
triplet girls at home! With seven kids of your own, I'm sure you did your fair
share of multi-tasking. I look forward to finishing the book soon. Thanks again
for getting such a great investing book out in the marketplace."
And H.V. Kaelbar writes: "I think John Mauldin has done it again! I'm a regular
reader of his newsletters and am happy when I get to read his work in book form.
He also makes the rounds with some of the most brilliant minds in the industry
today and shares his knowledge quite generously.
"In this book, he has given the spotlight to some of his very smart colleagues -
some having previously published books and articles and some not. Yet all are
recognizable names to me.
"I'm a money manager and really appreciate how these bright minds help stretch
my thinking such that I do not remain anchored to one sided beliefs. But their
work is not just for professionals! They write in a way that novices can
understand. All the contributors are a credit to the industry. Thanks guys."
You can get the book at your local bookstore or at this link:
www.amazon.com/justonething. Now to the yield curve.
The Most Accurate Predictor of Recessions
I have written about the yield curve more than any other single topic in the
almost six years of writing this letter. There is a justifiable reason to pay
attention to the yield curve. In certain very specific circumstances, it has
been the single most reliable predictor of recessions. Let's examine what those
circumstances are.
First, the yield curve is a graphic depiction of the relationship between the
yield on bonds of the same credit quality but different maturities. Normally,
you expect to get more interest paid to you for holding a longer maturity, as in
theory there is more risk to holding a bond for ten years than for 90 days, or
for 30 years as opposed to a mere ten years. You can go to
http://www.bloomberg.com/markets/rates/index.html and see an up-to-the-minute
graph on the yield curve for US treasuries. At 4:00 pm Eastern time on December
30 it looked like this:
This is of course highly unusual. Most of the time the curve or graph will start
in the lower right and rise to the upper right. Today it sags in the middle,
which means that yields on the two year note is paying more than the ten year
bond.
When a shorter maturity note pays more than a longer maturity note or bond, the
curve is said to be inverted. There are times when the entire yield curve goes
from the upper left to then lower right on the graph. When this happens the
yield curve is said to be fully inverted. As we will see below, how far the
yield curve inverts gives us a percentage probability of the likelihood of a
recession within 4-6 quarters. So, we pay attention to this curve.
Now, let's review a little history. Professor Campbell Harvey of Duke was the
one that wrote about the relationship between recessions and the yield curve,
and proved that the yield curve outperformed other forecasting tools in his 1986
dissertation at the University of Chicago. He published his dissertation in 1988
in the Journal of Financial Economics. In 1989, he published a follow up piece
in the Financial Analysts Journal. Estrella (we'll read more about him later)
and Hardouvelis picked up on the idea and published an article in 1989 and a few
more.
Harvey's prediction about the usefulness of the yield curve was right on target.
In 1991, after the 1990 recession he noted that inversions of the yield curve
(short-term rates greater than long term rates) have preceded the last five US
recessions, suggesting that the curve can accurately forecast the turning points
of the business cycle.
(As an aside, Campbell has a great web site with over 8,000 financial and
economic terms defined. It is a great resource: http://www.duke.edu/~charvey/)
Fast forward to 1996. Arturo Estrella and Frederic S. Mishkin, economists for
the New York Federal Reserve Bank, wrote an article in the "Current Issues in
Economics and Finance" which is published by the New York Federal Reserve Bank.
In it, they compare the usefulness of the yield curve as a prediction tool to
other indicators:
"The yield curve--specifically, the spread between the interest rates on the
ten-year Treasury note and the three-month Treasury bill--is a valuable
forecasting tool. It is simple to use and significantly outperforms other
financial and macroeconomic indicators in predicting recessions two to six
quarters ahead."
They compared the yield curve with three other possible indicators, including
the so called "leading economic indicators" from the Conference Board. The only
reliable predictor four quarters out was the yield curve spread.
In September 2000 the yield curve was seriously inverting. I called Estrella to
talk about the importance of the curve. I wrote then:
'First, he told me he had done another study in 1998 comparing even more
predictors. The latest study involved 30 potential predictors of a recession.
The conclusion of that study is that the 90 day average of the yield curve was
the most reliable predictor of the 30 they studied, so score one for taking this
current situation more seriously."
You can read the first paper at
http://www.newyorkfed.org/research/current_issues/ci2-7.pdf. The second paper
was a private study and is to my knowledge not published on the web, although I
did get and read a copy at the time.
The paper that they published used the spread between the 90 day T-bill and the
ten year bond. For the record, the average ten year bond since 1982 has yielded
7.31%, the average 90 day T-bill was 5.49% and the average spread was 1.82%. For
the record, today we have the 90 day at 4.08%, the ten year at 4.39% for a
difference of 0.31%.
They used the 90 day average of the spread rather than the actual one day
spread. This is important. There are several times where the yield curve
inverted for a few days but did not stay that way for long. Recessions did not
follow.
So, the fact that the two year and the ten year inverted this week does not mean
we will see a recession next year. In fact, it may not mean anything other than
it was a slow week in the bond pits. We saw the spread on the yield curve
roughly where it is today in 1996. It was four years later that we had a
recession. Hear is a graph of the 90 day-ten year yield curve spread.
Maybe things will get back to normal come next week when all the traders get
back from Aspen and the Caribbean, having left the trading desks to their
assistants. Yet, as we will see below, the inversion is not without interest to
investors. So what can meaning can we draw?
Estimated Recession Probabilities
Estrella and Mishkin developed a probability table about how likely a recession
would be 4 quarters later given a particular level of the yield curve spread.
Let's look at that table from the 1996 paper.
The spread in the table above is the 90 day average. Basically, if the spread is
0.46 basis points, there is a 15% probability of a recession four quarters
later. And that is roughly where we are today. The 90 day average is 0.52%.
But that level of spread has happened several times in the past 40 years and we
have not had a recession follow. So why should we pay attention today?
Because for a full inverted yield curve to show up you will start seeing "signs"
in the yield curve like we saw this week. These things start innocuously,
usually when the economy seems to be booming, and most observers suggest we
ignore them. And sometimes they are right.
But most observers suggested we ignore full-blown yield curve inversions as
well. I think it was something like 50 out of 50 Blue Chip economists failed to
predict the last recession even a few months out. They ignored the yield curve,
all finding reasons why "this time it's different."
In a follow-on paper mentioned below, Estrella documents that each of the
previous yield curve recessions since 1978 produced major academic papers
telling us why this time it's different. They were all wrong. If we have another
yield curve inversion, we will have another spate of papers and economists
suggesting that we ignore the curve as well. That is one prediction you can take
to the bank.
The Fed funds rate is at 4.25%. It is highly likely it will go to 4.5% at the
end of January. If the ten year does not move upward, you could see the
beginning of a full yield curve inversion. That will put us on "official" yield
curve watch. Since that seems like a real possibility, let's look at some of the
specific points in the 1996 paper.
In 1989, the yield spread predicted a 25% probability of a recession showing up
in 1990 and one did. It was mild, but that was small comfort to those who got
caught in its trap.
Further, the Fed paper authors tell us that things have changed and that now we
should be much more concerned about a "mere" 25% probability. Quoting:
"Thus, even a probability of recession of 25 percent--the figure forecast for
the fourth quarter of 1990 data on the yield curve spread one year earlier--was
a relatively strong signal in the fourth quarter of 1989 that a recession might
come one year in the future."
Further down they say,
"There are two reasons why the signal for this [1990] recession may have been
weaker than for earlier recessions. First, restrictive monetary policy probably
induced the 1973-75, 1980 and 1981-82 recessions, but it played a much smaller
role in the 1990-91 recession. Because the tightening of monetary policy also
affects the yield curve, we would expect the signal to be more pronounced at
such times. Second, the amount of variation in the yield curve spread has
changed over time and was much less in the 1990s than in the early 1980s, making
a strong signal for the 1990-91 recession difficult to obtain."
Basically they are saying that future studies a few decades from now will
probably have much higher probabilities of recession at lower spreads than did
their study because things, like volatility, have changed.
The 90 day yield curve in 1990 only went to a negative (-) 0.13%. It got to
-0.71% at the end of 2000, with the worst one day number being January 2 of 2001
when it was -0.95%. Interestingly, from that point the spread went positive in
less than a month. (For what it's worth, the weeks around Christmas and New
Years saw really odd and wild volatility.)
The 10 Year - 30 Year Connection
The Treasury plans to start issuing new 30 year bonds in February. This will be
of interest as there is an interesting relationship I have noted back in 2000
between the ten year and the 30 year bond.
"Just for kicks, I went to the Federal Reserve web site
(http://www.federalreserve.gov/Releases/H15/data.htm) and downloaded the
interest rates on 10 year and 30 year bonds since 1977. Then I did a comparison.
Curiously, it is not at all uncommon for the 10 year rate to go above the 30
year rate.
"In fact, it seems to happen about 18 months or so before a recession or a stock
market crash. Not just one time but every time the 10 year/30 year rates became
inverted since 1980 we had either a recession (in 1980, 1982 and 1990) or the
'87 stock market crash.
"I should point out that in 1987 we did not see an overall negative yield curve
while we did prior to the recession years."
For the record, Bloomberg says the 30 year is at 4.54%. Since there are no
actual 30 year bonds (the longest note would be about 25 years), I assume they
have some method for giving us this number. No matter, in a few months we will
have a real number. And we can then compare it to the ten year.
If for some reason that 30 year drops below the ten, you can bet many economists
will argue that it is a result of the Fed not offering enough 30 year bonds so
that demand drove the rates down. I should point out they made very similar
arguments in 2000. Of course, when things went back to normal in late 2000,
those arguments began to ring hollow. They will this next time as well.
You can learn more about interest rates and the yield curve at my friend Ed
Easterling's very useful work at
www.crestmontresearch.com/content/irates.htm. There are some very good
graphs which make the whole historical yield curve picture come to life.
Some Conclusions
Arturo Estrella is now the Senior Vice President, Capital Markets Function
Federal Reserve Bank of New York. In October of this year, he produced a very
useful primer on the yield curve at
http://www.newyorkfed.org/research/capital_markets/ycfaq.html. For those of you
who want more on the academic research on yield curves, I highly recommend it.
He concludes it with the following question and answer. It is instructive for us
to look at what he says (emphasis mine):
"Q. Should we expect the predictive power of the term spread for real activity
to persist?
"A. Accumulated experience with the forecasting power of the yield curve
suggests that it is much more than a passing phenomenon. Warnings of its actual
or possible demise are often voiced, as in Butler (1978), Furlong (1989), Watson
(1991) and - to some extent - Dotsey (1998), but the fact remains that
recessions still seem to follow inversions quite inevitably, as recently as in
2000-2001.
"Like many empirical models, some formal predictive models that forecast output
growth based on the term spread seem to have a structural break around
1979-1980. Stock and Watson (2003) find substantial evidence of a break for
models that predict output growth and Estrella, Rodrigues and Schich (2003) find
more modest evidence for models that predict industrial production.
"However, this evidence does not necessarily imply that the predictive power of
the yield curve has disappeared altogether, only that the values of the
parameters in the formal models may have changed. Models of a more qualitative
nature, such as those that predict recessions, seem to be affected much less or
not at all, as documented by Estrella, Rodrigues and Schich (2003). Theory
suggests (e.g., Estrella (2005a)) that there is a persistent predictive
relationship between term spreads and future real output, though the precise
parameters may change over time.
"Since yield curve inversions and economic recessions correspond to extreme
values of those variables, a connection between inversions and recessions may be
systematically detectable even if parameters change over time within reasonable
bounds. Thus, although yield curve inversions may not be followed by recessions
as a matter of universal mathematical principle, they should definitely raise
warning flags about future output growth."
Let's draw this letter and the year to a close with a few observations. Even if
the yield curve does fully invert, it suggests that we will not see an outright
recession in 2006? Why? Because to get a 90 day average negative number is going
to take close to 90 days. If we get there, a recession is still at least 3-4
quarters away.
That does not mean we could not see the beginnings of a slowdown. In fact, if we
do see an inversion, it would suggest a slowdown in the latter part of 2006 is
likely. Remember, we never go directly to a recession from a strong economy like
we have today. It takes time to slow an economy down.
Secondly, the stock market drops an average of 43% before and during a
recession. That is an ugly number. But it is a very real number. And you do NOT
want to wait until the last moment to head for the sidelines. Much of the drop
in the market will happen prior to a recession, and we only know if there was a
recession in hindsight. Usually, by the time we find we are in a recession, it
is time to start buying.
Third, there are going to be a lot of people arguing that this time it's
different if we do get a full blown inversion. And to be perfectly candid with
you, it may be. I will go over that rationale in some future letter. But I will
tell you this, I highly doubt I will buy it. When you have something as reliable
as the yield curve telling you there are problems in Dodge City, it may be time
to think about leaving town. Perhaps new sheriff Ben Bernanke can solve the
problem before it emerges. But I am not sure I want to bet my portfolio on his
ability.
Is it time to head for the hills yet on your index funds? Not really. The yield
curve is not really telling us anything other than to pay attention at this
time. So we will. I should note that many indices other than the internet bubble
NASDAQ were not that far from their highs in July of 2000 when the yield curve
started to show serious problems. In fact, the markets went up for a month or so
following that negative inversion.
2006 Forecast, London and More
Next week is my annual forecast issue. I am doing my usual intense research for
this issue. It is always the hardest one for me to write in any given year. It
generally takes two full days instead of the normal 5-6 hours.
I can make a few forecasts now. 2006 is going to be the busiest year I have had
in a long time. We are launching a new service for investors in the first
quarters, assuming the attorneys sign of on all the copy. I will be recommending
a small number of investment advisors and funds which will be available to the
average investor. I am pretty excited about our prospective line-up, although we
will always be on the lookout for new managers.
I am finally going to start a new book I have been planning for over 6 years.
More details next week. For those of you who wrote offering to help, I will be
in contact shortly. This is going to be fun.
I will be in London February 15 where I am going to guest host on CNBC Squawbox
(Europe). I will be in New York January 30 speaking at a hedge fund conference
on finding emerging hedge funds. Details on this conference next week. Detroit,
Toronto, Miami and La Jolla are also on the schedule for January.
It is time to hit the send button on this week's letter, as well as 2005. I am
ready and excited about 2006. I always seem to think the next year will be my
best ever. And sometimes it is! I find my optimism about the new year is no
different, although I can see a few bumps I am going to have to iron out. But
they are good kind of problems. As my Dad said, if it was easy, then anyone
could it! And you wouldn't make any money. It is only the hard stuff that really
pays.
Lucky for me, I get hard stuff that is also a lot of fun. And I get to write to
the greatest group of readers any analyst could have. I consider each and every
one of you my friends and I take writing to you very seriously. Thank you for
letting me come into your life this last year. I look forward to an even more
exciting 2006! I would be even more excited if I could get my inbox empty before
Tuesday morning. But some things will never change.
This weekend will find me with family and friends. I promised my young son I
would take him to King Kong tonight. I really am not looking forward to it, even
though the reviews are great, as I don't like movies with sad endings. And we do
know how this one will end. Stay safe this weekend!
Let me wish you a very Happy New Year!
Your really ready for 2006 analyst,
John Mauldin
JohnMauldin@InvestorsInsight.com
www.2000wave.com
December 31, 2005
Copyright 2005 John Mauldin. All Rights Reserved.
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John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.
Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above.
PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.
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