A Major Economic Indicator Looks Like It May Start Flashing Danger Soon

By Robert Wenzel

The yield curve, the interest rate on long-term interest rates (generally measured by the 10 year Treasury note) minus the interest rate on short-term Treasury rates (generally measured by the 2 year note) is narrowing significantly.

It is at a positive 30 basis points. This is way down over the last 10 years.

Click on chart for larger view.

I have discussed the yield curve for years at the EPJ Daily Alert. Now, as the yield curve gets closer to negative territory, mainstream media is starting to put heavy focus on the curve. This is pretty new. I can recall decades back when there were only maybe 100 people that followed the yield curve and understood its importance as an indicator.

I run the chart below from time to time in the  EPJ Daily Alert. It shows how the yield curve going negative  (short rates higher than long rates) has led to recessions. The red dash line is the yield curve going negative the R in the shaded area indicates periods of recession.


Now, I hasten to add that
past history does not mean the future will turn out the same but there is a very good reason why the yield curve is such a powerful indicator though few get why. Indeed, I have seen so-called Austrian scholars ramble on in essays about the yield curve but never get to the point of why the curve is such a remarkable indicator of recession.

The reason is simple, under the fractional reserve system in operation in the United States that is propped up by the Federal Reserve, banks tend to borrow a lot of funds short-term and lend them out long-term. When the yield curve turns negative, it is no longer profitable for banks to make these type of loans. It then results in the shrinking of the number of loans made. Thus, according to Austrian School Cycle Business Theory, the shrinking in the loan market will result in a collapse of the Federal Reserve manipulated capital-consumption structure, which leads to a collapse of the stock market and recession.

Now at present, there are some very unusual things going on with the money supply that I have never seen before (I report on them in the ALERT), so it is possible that we could get a recession and/or stock market crash without the curve going negative but right now the yield curve itself continues to dive.

Whatsmore, the latest Federal Reserve minutes indicate that some Fed monetary policy members think that it is different this time and that a negative yield curve will not mean recession!

From the Fed minutes (my highlight):

Meeting participants also discussed the term structure of interest rates and what a flattening of the yield curve might signal about economic activity going forward. Participants pointed to a number of factors, other than the gradual rise of the federal funds rate, that could contribute to a reduction in the spread between long-term and short-term Treasury yields, including a reduction in investors' estimates of the longer-run neutral real interest rate; lower longer-term inflation expectations; or a lower level of term premiums in recent years relative to historical experience reflecting, in part, central bank asset purchases. Some participants noted that such factors might temper the reliability of the slope of the yield curve as an indicator of future economic activity; however, several others expressed doubt about whether such factors were distorting the information content of the yield curve. A number of participants thought it would be important to continue to monitor the slope of the yield curve, given the historical regularity that an inverted yield curve has indicated an increased risk of recession in the United States. 

In other words, the Fed may take us into negative territory on the yield curve by continuing to raise short-term interest rates, justifying it on the basis that it's different this time! (Side note: The Fed shouldn't be manipulating the money supply at all.)

Robert Wenzel is Editor & Publisher of  EconomicPolicyJournal.com and Target Liberty. He also writes EPJ Daily Alert and is author of "Foundations of Private Property Society Theory: Anarchism for the Civilized Person" and also The Fed Flunks: My Speech at the New York Federal Reserve Bank. Follow him on twitter:@wenzeleconomics and on LinkedIn. His youtube series is here: Robert Wenzel Talks Economics. The Robert Wenzel podcast is on  iphone and stitcher.