13 Jan 2016

Inverted Yield Curve and Recessions

*Choice*, Austrian School, Shameless Self-Promotion 10 Comments

The 3-month and 1-year Treasury yields have gone way up in the past year, but the overall spread (say between them and the 10-year) is still quite positive, so the classic warning of an impending recession is still not here. Here’s a long-term chart:

In the chart above, the red line is the 10-year yield, the green line is the 3-month yield, and the blue line is the difference between them.

So, if you just look at the blue line and the recession bars, you can see that the blue line always goes negative before a recession.

But by decomposing it, you can see that specifically what happens is that short rates zoom upward to exceed long rates. (In principle the yield curve could invert if long rates collapsed below short rates. But this chart shows, that’s not how it actually happens historically.)

In this paper, I argue that the Austrian business cycle theory, among its other virtues, can explain the predictive power of the yield curve. Specifically, central banks have more control over short rates than long rates. So in standard Austrian theory we say the central bank “raises rates” and this causes the boom to turn to a bust. Well, when you get more specific about it, that would mean short rates go up while long rates (which are a combination of expected real growth and price inflation) will stay put or possibly even go down.

So, if you buy the basic story of ABCT, then out pops the fact that an inverted yield curve “predicts” recessions as a bonus.

** For a full explanation of the Austrian theory of the business cycle, see my new book Choice from the Independent Institute.

10 Responses to “Inverted Yield Curve and Recessions”

  1. E. Harding says:

    “Well, when you get more specific about it, that would mean short rates go up while long rates (which are a combination of expected real growth and price inflation) will stay put or possibly even go down.”

    -Eh, not quite:


    Interest rates were also quite high in the late 19th century and quite low in the mid-20th, despite the fact real growth was higher in the latter than in the former.

    • Bob Murphy says:

      E. Harding what does that chart, or your comment about 19th century, have to do with my claim? I’m saying in Austrian theory, when we say the banks raise rates and that causes the crash, that strictly speaking they are raising short term rates.

      • E. Harding says:

        Just a small quibble about the causes of long-term rates.

  2. Tel says:

    The artificially cheap credit engenders a boom period, which may last for several years. During the boom, prices often begin rising at an accelerating rate, which may shift the entire yield curve up, but may increase long-term rates the most, due to uncertainty over future (price) inflation. In short, the “good times” of apparent prosperity—in the eyes of mainstream economists—are associated with an upward sloping yield curve.

    The boom is unsustainable. Regardless of what the banks do, the economy eventually must crash with the complete collapse of the currency. However, in practice the banks often abandon their inflationary policies well before this point, so that the immediate “cause” of the recession is the rise in short-term rates.

    But this time around, the central banks have managed to keep prices reasonably stable and there has not been the sort of accelerating price inflation that drives up long term rates. Indeed the long term fixed mortgage rate keeps dropping.

    Arguably there hasn’t been a boom.since 2007 either, the central bank has not abandoned “inflationary policy” with short term rates close to zero and only the slightest rate rise last year, very unlikely to rush into another rate rise soon.

    Yet despite all that, plenty of signs of recession around us. Mostly lack of employment and poor sales figures, as well as slumping commodities prices largely because no one is buying those commodities (special case with oil, but ignore that one).

    • Levi Russell says:

      Can’t that be explained by IOR?

      If IOR, then low inflation

      If IOR, recession thanks to low investment


      • Tel says:

        Well IOR puts us into uncharted territory, and also having ultra-low short term interest rates at the start of a downturn cycle puts us into uncharted territory, and beyond that, just looking at Bob’s chart above with the green line slamming the floor like that says the charts are in uncharted territory.

        All of which seems to suggest that the earlier rules about inverted yield probably don’t apply. Something different is going to happen here.

        Then again, short term rates between banks are not really market rates in any sense of the word… they are pretty much completely decoupled from the market. Looking at other rates like overdraft rayes and mortgage rates is at least somewhat more meaningful.

        • Maurizio says:

          “just looking at Bob’s chart above with the green line slamming the floor like that says the charts are in uncharted territory”

          Going back in history, there’s never been a recession that started while the green line was on the floor?

          • Tel says:

            It’s never been that low before for that long at all, regardless of recession or not. On the FRED charts, the history starts in 1982 just like Bob’s chart shows.

            However, the 3 YEAR treasury has a longer history (bck to 1953) and still has never been so low for so long.


            Same for the 5 YEAR Treasury constant maturity rate, BTW. All of them lower than anywhere else on the series.

  3. skylien says:

    Obviously this signal of a recession would lose ist significance if enough people happen to react on it that way. However it is going to be interesting if and when the yield curve inverts before the next official recession.

  4. Innocent says:

    Lets see if it has predictive power. Does it track in other countries as well is the question. If so I think you may have something. But right now the yield is essentially 0 on the 3 month. How will that change things?

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