Studies show a flat to inverted yield curve has been a reliable leading indicator of slower growth and recessions. This bodes ill for Brazil, India, China, and Australia. Meanwhile, the Japan experience shows when central banks have short term interest rates capped, shifts that flattened the yield curve preceded post bust recessions. This applies to the US.
Bloomberg is out with a couple conflicting stories on the yield curve. The first ignores the evidence above, pointing to the historically wide difference between 10 year and 30 year, which suggests there will not be a recession.
The economy has never contracted with the difference between 10- and 30-year Treasury yields as wide as the current 1.34 percentage points, or 134 basis points, since the so-called long bond was first issued in 1977. The gap, which is more than double the 49 basis-point average of the past 20 years, has ranged from negative 56 to positive 41.9 at the start of the last five recessions, beginning in January 1980.
“If you really think we are going in the direction of anything resembling Japan you have to see the full length of the curve flatten like it did in Japan, and that isn’t happening.”
Meanwhile, MKM Partners still sees a lot of similarities between the US and Japan.
The Treasury yield curve’s flattening indicates the U.S. is on the cusp of a recession similar to what afflicted Japan in the late 1990s, according to MKM Partners LLC’s Michael Darda.
The extra yield investors get to hold U.S. 10-year notes instead of two-year debt shrank today (8/19/2011) to 1.91 percentage points, the narrowest since April 2009. Japan slipped into a recession during the second half of 1997, when the spread between its 10- and two-year government bonds collapsed below 1.75 percentage points, according to Darda, chief economist at the research and trading firm, during a radio interview on “Bloomberg Surveillance” with Tom Keene and Ken Prewitt.
Meanwhile, inflation expectations are on the rise.
The five-year, five-year forward breakeven rate, a gauge the Fed uses to help determine monetary policy because it projects the pace of price increases starting in 2016, ended last week at 2.77 percent. The rate has averaged 2.8 percent the past five years. The cost of living rose at a 1.8 percent annual pace in July, excluding food and energy costs, the most in more than a year, the Labor Department said Aug. 18.
Whether or not the US officially enters a recession soon is somewhat irrelevant. Slower growth is here and continuing, while inflation is increasing. Stagflation remains the primary theme. It’s important to keep in mind the correlation between GDP and the stock market is near zero.
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