Yield curve is wrong now—prefer ev from the inventor of the yield curve indicator

The inverted yield curve is Wall Street’s most obsessed-over recession indicator, with a track record of foreshadowing every downturn since 1960 with no false signals. But since last year it’s been screaming downturn and no U.S. recession has come, leading some analysts to wonder if the metric is broken.

Not so fast, according to Duke University finance professor Campbell Harvey, the Canadian-born economist who pioneered it.

In simple terms, the yield curve shows how interest rates or yields on different maturities of government bonds compare. Yield is what bondholders are paid for their loyalty. Traditionally, the longer investors lock in, the more they expect to be compensated to account for risk and inflation. As such, when the economy is functioning well, rates on long-term bonds are higher than short-term bond rates.

Every so often, though, the relationship flips, or inverts, and short-term rates become higher. When that’s happened, recession has always followed. In the past four recessions (excluding the one brought on by COVID-19) the average lead time was 13 months from inversion to recession, but ranged between seven and 21 months.

Prof. Harvey was the first to discover the yield-curve dynamic, though the indicator’s Toronto roots are generally overlooked.

In 1982, he was a young master’s student at Toronto’s York University when he landed a summer placement at then Canadian mining giant Falconbridge Ltd. and his bosses tasked him with developing a model to forecast real U.S. economic growth. “They put a first-year intern with no background in mining or experience in charge of the single most important number for all of corporate planning,” he said.

Rather than try to emulate the forecasts put out by big-budget econometrics firms, with their squads of PhDs and complex models, he looked at what the bond market could say about future growth and began to notice the inverted yield-curve pattern.

Before he could present his findings about predicting future recessions, the recession that was already under way at the time caused Falconbridge to axe its whole corporate development team, including Prof. Harvey, to cut costs. He finished his research for his dissertation at the University of Chicago and the inverted yield curve was born.

In November, 2022, the yield on three-month U.S. Treasury bills rose higher than the yield on 10-year government bonds, and so the yield curve was said to have inverted. The curve between two-year bond and 10-year bond yields had inverted months earlier. But because that measure has sent false signals in the past, Prof. Harvey prefers his original model that uses three-month Treasuries.

Whatever the measure, yield-curve inversion was a big part of the recession angst that began last year. Yet this past January, Prof. Harvey was still in the camp that believed his indicator might be getting it wrong. That’s because of the strength of consumer balance sheets and the robust demand for labour as the pandemic has eased.

At the same time, the popularity of the inverted yield-curve indicator itself means it has begun influencing how companies behave. They are less likely to bet the firm on major investments after an inversion has occurred, and they may trim staff as a precaution. This has the potential to slow growth, but also means companies are less likely to find themselves in a crisis and forced to make large, painful job cuts later. These choices make a soft landing more likely.

“In the past, the yield curve was just reflecting what people thought was going to happen, but now the yield curve is a self-fulfilling prophecy,” he said.

When Prof. Harvey put all that together in January, he believed the inverted yield curve might register its first false prediction and the U.S. could skirt recession. But he warned that could all change if the U.S. Federal Reserve kept increasing rates.