One of the most reliable indicators for the state of economic
conditions in the U.S. over the past 75 years has been the shape of
the Treasury yield curve.
Taking the difference between the yield of a longer term
Treasury bond and the yield on a shorter term Treasury such as the
10 year (NYSEARCA:IEF) minus the 2 year (NYSEARCA:SHY) provides the
current level of the yield curve. With the 10 year currently
around 2.6% and the 2 year at 0.4%, today the yield curve sits at
2.2%, near the upper end of its historical spectrum. Other
similar yield curve measurements use the 5 year minus the 3 month
or some other combination of longer term rate (CHICAGOOPTIONS:^FVX)
less a shorter term rate.
One of the primary goals of the yield curve is to get an idea of
inflation expectations (NYSEARCA:SCHP) and risk in the lending
markets. During "normal" times the yield curve is positively
sloped with the duration farther out in time yielding more than
bonds with shorter durations.
A profitable strategy that helps you choose
An abnormal, or inverted yield curve, occurs when longer term
rates fall below short term rates. This is typically caused
by a falling long term yield as investors demand the safety of the
longer term bonds driving their prices higher and rates down.
However, these precedents and historical structures all existed
in a world pre-ZIRP (zero interest rate policies).
Historical Yield Curves
The first chart below shows the historical curve of the U.S.'s
10 year Treasury yield less the 3 month Treasury yield. Since
the 1950s an inverted curve (when the curve has fallen below zero)
has occurred seven times, preceding seven of the last eight
recessions with the lone non-signal (1960) also very close to
Indeed an inverted yield curve has been a great predictor of
slowing economic growth (
) as well as recessions and is something many investors are again
watching as a sign for a slowdown. But, I am afraid they will
be looking for something that may never come.
Something changed in the 2000′s as the Fed adopted its zero
interest rate policy "indefinitely", keeping short term rates glued
near zero percent. In such an environment the only way to get
an official yield curve inversion is for long term rates to fall
below the shorter term rates now under 1%, something that would be
However, although unprecedented in the United States, this song
has already been danced to elsewhere.
Japan's Last Yield Curve Inversion Was in the Early
The next chart shows Japan's yield curve since the early
1970′s. Notice how it has not dipped below zero since the
early 1990′s even though on this chart there has been three
In fact, Japan has seen numerous recessions although its yield
curve never inverted as the short term rate has stayed below the 10
year rate displayed by the next chart.
This chart through 2014 shows 1998's, 2001's, 2004's, 2008's,
and 2011's recessions in Japan all occurred without an inverted
yield curve, even though Japan's former history also showed the
yield curve to be a great recession predictor.
Instead, since the mid-1990′s a flattening of the curve as
opposed to a full inversion was all the warning provided for an
A History Lesson for the Fed
So, what happened in the mid-1990′s to make Japan's yield curve
inversion no longer a recession predictor?
The Bank of Japan started lowering discount rates toward zero in
an effort to counter deflationary forces; sound familiar?
20 years later Japan maintains its short term discount rate
below 1% and the Federal Reserve Bank of the United States also has
now adopted a similar very low discount rate policy
The inverted yield curve may have worked well during times of
inflation, but during times of deflation and low short term
interest rates, its predictive power falls apart. Instead
investors should watch for just a flattening of the curve instead
of an outright inversion as occurred in all the Japanese recessions
since the mid-1990′s to warn of the U.S.'s next recession.
Given the extremely low interest and inflation rates, deflation
remains the key risk to your investment portfolio as we outlined in
our March Newsletter where we discussed one way to take advantage
of deflation through the U.S. Dollar (NYSEARCA:UUP). Its
price is putting together a bullish long term chart pattern and
should benefit as deflation continues. We also discussed the
implications a stronger dollar would have on commodities such as
gold (NYSEARCA:GLD), which has already seen a 5% decline since due
to U.S. dollar strength.
History teaches us that with such low interest rate policies,
the U.S. is likely not to see an inverted yield curve again, but
this does not mean recessions should not be expected as Japan has
had five of them since adopting their version of ZIRP, dealing with
deflation for over twenty years now.
Profit Strategy Newsletter
analyzes the world's markets to keep you ahead of major market
trends. Japan remains the best macro example for the U.S.'s
monetary policy as their similar ZIRP policy has gotten rid of
inverted yield curves, but not recessions or deflation.
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