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Do yield curves predict recessions?

| Posted by: Paul Donovan | Tags: Paul Donovan

There is a theory that the shape of the yield curve predicts economic recessions. This theory would suggest that bond traders have some extraordinary insight into the future of the economy, denied to lesser mortals. Sadly, as Fed Chair Yellen indicated at the last press conference, this is not true.

Historically, yield curves were sometimes correlated with the economic cycle. Correlation is not causation. Historically, inflation was a more important part of a bond yield, inflation was cyclically correlated, and central banks were determined to squeeze inflation from the economy. Higher central bank rates were expected to slow the economy, lowering inflation and therefore bond yields.

Today, central banks are not tightening to lower inflation, but instead to maintain a balance (Monday's comment, available here). Inflation is more influenced by non-market prices (Tuesday's comment, available here). And the real yield is now a more important part of a bond yield.

Real yields are distorted because bond markets are rigged. An overwhelming majority of US Treasuries are owned by investors who do not want to own Treasuries – they have to own Treasuries. These investors do not buy bonds based on anticipated returns. Real yields are increasingly unrelated to the real economy.