For those of you out there who love good economic data, FRED (the economic database for the Federal Reserve) has some cool new features. On top of their newly designed interactive graphs launched late last year, they most recently added the ability to create a dashboard to keep track of all your favorite economic indicators in real time.
One thing that economically attuned people like to keep their eye on is the spread (or difference) between short term and long term treasury rates. The primary reason people like to follow the spread is because it is one of the best indicators of a recession.
Normally individuals receive a higher yield (or more money) when they invest in long-term treasury notes. This has to do with the additional risk you take being separated from your money for a much longer time. Often the spread is referred to as a yield curve and when you look at the yield rates below, it is easy to see why.
However, sometimes market forces make that curve flip, so it slopes downward, known as an inverted or negative yield curve.
The really interesting thing is, over the past 50 years in the United States, economists have found that these negative yield curves to be downright useful in predicting the onset of a recession. In fact, out of the last ten times a 1-year treasury note (or bill) held a higher yield than a 3, 5, 10, and 20-year treasury note, nine have been followed by a recession within 18 months. You can pan your mouse over the graph below and see for yourself.
Note, this figure shows the longer-term rate minus the one-year rate; thus, when the result is below the line at “0” the one-year rate is higher than the other rates.
As you might expect, a large number of articles have been published on this subject. Generally, it is thought that the spread becomes negative because investors demand more long term bonds when they expect interest rates to fall in the near term (due to intervention from the Federal Reserve). To understand this dynamic better, let us suppose there were two investors in November of 2006. One chose to invest in 3-month treasury bills because they had the highest yield (5.07%) while the second thought those rates would soon fall and chose a 5-year investment for 4.58%. Two years later the first investor is getting a return of 0.19% on 3-month investments the second is still making the locked in at 4.58% and outperforming all but the longest-term investments.
This trend does not always hold true in other economies. There are examples of Australia and the United Kingdom experiencing a negative yield curve while their economies continued to grow at a robust rate. Several economists reiterate the warning on your mutual fund “past performance does not necessarily predict future results” and argue that new economic realities mean that negative yields in the future will no longer predict economic recessions. Art Laffer – a famous supply side economist and father of the Laffer Curve – made the argument in 2007 that it would be “different this time,” that we weren’t in trouble for a recession even though the treasury spread became negative. It is now quite clear how different 2007 really was.
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