Why The 'Flawless' Recession Indicator May Be Wrong This Time

The U.S. Treasury yield curve, which is closely monitored as a gauge of the health of the economy, inverted in November, signaling to bond investors that a U.S. recession is imminent.

However, Campbell Harvey — the economist who developed the indicator — recently told Bloomberg that the prediction is wrong this time around. So, are we getting a recession?

Before we get into that, let’s educate the uninitiated.

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Recessions in the U.S. have historically been preceded by an inverted yield curve. That's when rates for U.S. Treasury notes with a two-year maturity exceed those for notes with a ten-year maturity.

The yield falls off as the maturity date gets further away when the yield curve is inverted. And the inverted curve, also known as a negative yield curve, has historically been an accurate predictor of a recession — eight times out of eight, to be exact.

As a practical illustration, the current rate for ten-year notes is 3.79, whereas the rate for two-year notes is 4.40.

Makes sense, right? How does this precede a recession?

A yield curve provides insight into what many consider to be the current status of the economy. It can be used to predict shifting economic dynamics.

The yield curve provides a realistic picture of what is happening in the economy since it accurately captures the viewpoint of the majority of market participants.

As investors attempt to purchase longer-term bonds, short-term yields will increase if market participants are concerned about possible economic growth. Additionally, as the federal funds rate has a significant impact on bonds with shorter maturities, short-term yields will increase if the Federal Reserve raises interest rates.

Short-term yields will be lower and long-term yields will rise during a typical economic expansion.

Here’s where it gets tricky.

In Harvey's dissertation at the University of Chicago from 1986, he demonstrated a recession prediction model connected to the term structure of interest rates.

The Canadian economist extrapolated his model over the American economy going all the way back to 1968.

According to his research, the yield curve inverted eight times in the previous eight recessions before one was formally declared.

This time, though, Harvey says the indicator is flashing a false signal, and we may not get a recession.

“My yield-curve indicator has gone code red, and it’s 8 for 8 in forecasting recessions since 1968 — with no false alarms,” Harvey said in a interview Tuesday. “I have reasons to believe, however, that it is flashing a false signal.”

What’s the reason? Sentiment, that’s all.

Harvey created the inverted yield curve back in the 1980s. As the yield curve-growth relationship became so well known and extensively covered in finance media, Harvey said that it is decoupling from actual market risks as a result of investor behavior, or sentiment.

Due to this insight, businesses and consumers are reducing risk by boosting savings and avoiding large investment initiatives.

Moreover, a recession is less likely now that inflation expectations are inverted, which means investors see price pressures reducing over time, according to the economists' model, which was also connected to inflation-adjusted yields.

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“When you put all this together it suggests we could dodge the bullet,” Harvey said. “Avoiding the hard-landing — recession — and realizing slow growth or minor negative growth. If a recession arrives, it will be mild.”

A mild recession, if we get one, per the creator of the inverted yield curve.