FrameworkTechniqueMacro and ratesMarkets
The near end of the curve carries the recession signal, not the long end
(Don't Fear) The Yield Curve · 2018
The idea
Every rates interview eventually asks whether an inverted curve predicts a recession. The Fed note that answers it best compares two spreads. The near-term forward spread, the bill rate implied six quarters ahead against today's bill, isolates what the market expects policy to do. The long spread, ten years against two, mixes that with a term premium that moves for reasons unrelated to growth. In their model, once the near-term spread is in, the long spread adds almost nothing. The interview answer follows: an inverted curve says the market expects rate cuts, which usually means it expects trouble. It does not cause the downturn it anticipates.
An inverted curve is the market expecting cuts; read the near-term forward spread, because the long spread is diluted by the term premium.
When it works
Rates, macro and sales and trading interviews, and any time a headline says the curve has inverted.
When it may fail
The model is fitted to US cycles since the 1970s, a small sample, and the 2022 inversion was followed by a long wait. A signal with a thirty-five point effect is still a probability.
How to use it
Open the Curve Lab, build the near-term forward spread from the bill curve, and say what it implies about the path of policy. Then answer the recession question with the mechanism rather than the cliché.
Where it came from
Research (Don't Fear) The Yield Curve · Eric Engstrom and Steve Sharpe, Board of Governors of the Federal Reserve System (FEDS Notes)
What the source says. A one standard deviation fall in the near-term forward spread, about 80 basis points, raised the modelled recession probability by 35 percentage points, and with it in the model the long spread's effect was statistically indistinguishable from zero.
Connected ideas
Worth knowing first
A yield is expected short rates plus a term premium, and the premium is modelled, not seenTerm premium is an estimate from a model; say which model, and treat the level as less certain than the direction.
Says something similar
Split a move in the ten-year into expected policy and term premium with one rule of thumbA steepening is mostly term premium; a move in the two-year is half expectations, half premium. Use the rule, then say which model you trust.
Says something similar
Did rate hikes bring inflation down, or did the shocks fade? The careful answer is bothSupply shocks faded on their own; the hikes anchored expectations so the fading could happen. Credit both, in that order.
Concepts
Put it to work on L3VLUP
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