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Is the yield curve pointing to recession?

Key points:

  • The yield curve has been a good predictor of recessions. The last eight have been preceded by material flattening or inversion.
  • This appears a causal relationship, suggesting the signal from the curve should remain relevant even if the causes of curve flattening are different this time.
  • The yield curve slope proxies the degree of monetary policy accommodation and is key in determining credit conditions.
  • Two channels appear relevant. The slope of the curve statistically causes changes in bank lending standards. It also helps determine changes in credit spreads. Both channels work with two year lags.
  • Recession probability models suggest that we will not see a recession over the next 12-months.
  • We expect credit spreads to widen by 30 basis points in 2019 and 2020, which should reduce growth by 0.7 percentage point (ppt) and 0.8ppt respectively.
  • This material headwind to growth, alongside a fading fiscal stimulus, is likely to leave the US economy vulnerable to a material slowdown in 2020.

The curve and recessions

A tightening of US monetary policy has resulted in the US yield curve becoming flatter. With the Federal Reserve (Fed) expected to continue its policy of gradual rate increases over the coming quarters, a key measure of the yield curve slope, the difference between the ten-year and two-year US treasury yields, has recently reached its smallest since July 2007. In the following, we consider what we can learn from the yield curve about the outlook for future economic activity.

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