Inverting the Inverted Yield Curve Worries

There is nothing quite like a media fixated on high-frequency data to create instant financial stories. The current example: All the nattering yesterday about the inversion of the yield curve in the U.S. (long-term rates were lower than short-term rates, suggesting to some that economic weakness lay ahead).

While there is no doubt that an inverted yield curve is a powerful signal about the future health of the economy, it is also not a signal that should be read in without any nuances. The New York Federal Reserve has a good paper and faq on the subject, one highlight of which is the following:

Daily or even intraday changes in the term spread can be substantial. For example, for the spread between ten-year and 3-month rates, one-day changes of over 25 basis points occur about 2½ percent of the time. In some cases, these changes may be driven by market expectations of economic fundamentals and consequently may be persistent. In many instances, though, high-frequency changes in the spread may result from temporary demand or supply imbalances in the markets for Treasury securities, which may be quickly reversed and thus may not be truly reflective of changes in expectations about real economic conditions. One way to distinguish between perceived changes in  fundamentals and temporary market phenomena is to trace the persistence of yield curve signals. A signal that lasts only one day may be dismissed, but a signal that persists for a month or more should be looked at carefully. Statistically, these distinctions may be captured by using data averaged over one month or more ….

In other words, turning a one-day yield-curve inversion into front-page news may be entertaining, but it should, at the very least, be footnoted, “There is an excellent chance this is meaningless.”

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Comments

  1. Paul,
    Do not be so quick to dismiss this as mere MSM handwringing.
    When we look at the history of the Yield Curve, and place it into context with other variables — i.e., rising Oil proices and Fed tightenings — there is an excellent chance it IS quite meaningful.
    There is also the possibility that it is utterly meaningless — but I suspect that is a lesser probability . . .
    See the chart here for more details:
    http://bigpicture.typepad.com/comments/2005/08/recession_predi.html