Saturday, November 11, 2006

Treasury yield curve is not a surefire predictor for a recession

Despite a lot of the chatter, there is good reason to not consider the Treasury yield curve as an indicator of an imminent recession. The simple fact is that there is a lot of uncertainty about the trajectory of the economy over the next few months and the next year. There are plenty of reasons for a lot of demand for intermediate and longer-term Treasuries. A lot of money is still going into bond funds and a lot of people are incrementally approaching retirement age which means higher demand for fixed-income securities, which depresses yields. Yes, there are a lot of people who are (misguidedly) betting on a recession or near-recession next year, and their bests do add to the demand and do contribute to the inversion, but betting on an outcome doesn't necessarily make it so.

In addition, it is only in the past few years that foreign central banks have shifted to holding longer-term Treasuries rather than simply short-term T-bills for foreign exchange reserves. There simply isn't a large enough supply of T-bills to satisfy the demand Treasuries.

Quite a number of people continue to fail to comprehend the distinction between correlation and causality. Just because two variables might be in sync a number of times in the past does not necessarily imply causality. The studies that get quoted as to the correlation between Treasury yield curve inversions and recessions always add the caveat that the prediction reliability is not close to 100%.

Although the stock market has bounced back from the lows of 2002, but that may be due more to overall growth of the economy than a willingness of the average saver to bet on stocks. The result is that bond funds continue to remain popular, further depressing intermediate and longer-term yields.

Yes, there has been a significant increase in demand for intermediate and longer-term Treasuries, but that does not imply that a recession or dramatic growth slump is right around the corner.

-- Jack Krupansky


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