The Yield Curve and the Next Recession

John Cochrane:

The graph shows the 10 year government bond rate and the overnight Federal Funds rate, which the Fed controls. Notice how an “inverted” spread — when the funds rate is higher than the 10 year rate — is one of the most reliable indicators of a recession to come.

Notice that the yield spread is tightening now. So should we worry? Well, notice also the many times when the yield spread tightened… and then sat there for many years of growth. The late 1960s, the late 1980s, and the late 1990s are good examples.

"Notice also the many times when the yield spread tightened… and then sat there for many years of growth. The late 1960s, the late 1980s, and the late 1990s..."

Damn right. And this time is like the 1990s.

But is the spread really tightening now, as Cochrane says? To my eye, no.

To my eye, on Cochrane's graph the blue line hit bottom in mid-2012 and has been gradually rising since. Or, worst case, hit bottom in mid-2012, skidded along the bottom until mid-2016, and has been rising since. To my eye, the 10-year rate is keeping up with the Federal Funds rate. But that's why we do graphs: because we can't always believe our eye.

So I reconstructed John Cochrane's graph and added H-P trend lines to it:

Graph #2

Source data as thin lines, trends as heavy lines. Blue for the 10-year rate, red for the Federal Funds rate. Here's a close-up:

Graph #3

That blue line shows the "skidding along the bottom from 2013 to 2016. John Bull still can't stand two percent, apparently.

But it does seem that since 2015 or 2016, the red line is gaining on the blue. The gap between the H-P trend lines is definitely getting smaller.

Yeah, but there are known issues, known "end point" issues with the Hodrick-Prescott calculation. Since that last low in early 2016, for example, the blue data is going up faster than the blue trend. So I still think the blue data is climbing as fast as the red data.

Graph #4

Looking more closely, the red trend starts climbing by January 2015, while the  blue trend is still drifting down; running flat but drifting down. And yet, the red data is slower to rise than the red trend all thru 2015 and 2016.

And somehow, it looks like the red line rising is encouraging the blue to rise. Which is what's supposed to happen, I think.

I can see the heavy red line gaining on the heavy blue. But it is still not clear to me that the thin red line is gaining on the thin blue. Not since 2016.


If interest rates are rising now, rather than falling or running flat, then we are into a different trend. And if we're into a different trend, then I don't want to blur trends together by using H-P calcs that consider the whole dataset from the 1950s to 2018.

I want to see a close-up of this stuff, since 2016. 2016, because I think that's when the different trend starts. I subtracted the FedFunds data from the 10-year rate, to get the yield spread. And I re-figured the H-P numbers starting in January 2016, to eliminate all the influence of past trends. Here's what I got:

Graph #5

Oh you're right, you're right, mea culpa you're right. The yield spread is falling. The red line, sloping down, shows that the gap between the two interest rates is narrowing. I couldn't see it before.

When that red line gets to zero, the yield curve inverts. And we'll probably have a recession a year or two after that. Okay, so when will the yield curve invert?

I put a linear trend on the data and extended it out to see when it gets to zero:

Graph #6

Looks like a recession is due some time after 2026.

A non-linear trend line could predict an earlier recession, and let's call that realistic. But this year or next year or 2020? I don't see it.

As always, this is not investment advice.


Another look at the yield spread, based on Cochrane's data: The 10-year rate less the Federal Funds rate, since 1990.

Graph #7

Around 1995 there was a sharp drop almost to zero, and then five good years before there was a recession.

Around 2006, there was a sharp drop down to below zero, and a nasty recession a couple years later.

There has been no sharp drop this time around.

I eyeballed-in some red lines to show the trend of highs and lows for the last few years. Turns out that those trend lines meet some time around 2020.

Something has to change by then. But that doesn't mean recession is in the cards.