Predictions are hard, especially about the future, but they're a little bit easier if you look at the yield curve. Well, most of the time, at least.
Now let's back up a minute. The yield curve is just a line showing how much it costs the government to borrow from the very short to the very long-term. And it's also the best way to predict recessions. Why? Well, think about where long-term interest rates come from. They're the average of what markets expect short-term interest rates will be, plus a little extra to make up for the fact that something unexpected could happen. The longer the bond, the bigger that extra bit is, which, in part, is why the yield curve tends to be positive: shorter bonds usually have lower interest rates than longer ones.
But not always. Sometimes the yield curve inverts, and longer bonds are the ones that have lower rates. Now hold on. Why would people lend to the government for less tomorrow than today? Well, remember, long-term rates just reflect the average of expected short-term ones. So if longer rates are lower now, that means markets expect shorter ones to be lower in the future. And that tells us a lot. The Federal Reserve, after all, only cuts short-term interest rates to try to boost growth when the economy is slowing down. That means an inverted yield curve is the market's way of saying it looks like a recession is coming, and the Fed will have to slash rates to fight it.
And that brings us to a crazy-sounding question. Is the U.S. economy, despite the strongest job growth in 15 years, about to fall into recession? As Deutsche Bank's Torsten Slok points out, the yield curve isn't inverted, but it is inverting. So how worried should we be?
Not at all. Markets, you see, are the worst way to predict the future, except for all the others. (Sorry, Miss Cleo). Just take a look at the chart above. An inverted yield curve has, yes, predicted every recession, but it's also predicted six of the last three recessions. And if it inverts now, we can make that seven of the last three. That's because, even though the four most dangerous words in the English language are "this time is different," this time really is. Long-term rates are low right now for reasons that have nothing to do with the health of the economy.
Those reasons are the Federal Reserve and Europe. The Fed, you see, has stopped buying bonds, but is still holding the ones it's bought on its balance sheet — and that's what really matters. Think about it this way. The price of bonds, which move inversely with interest rates, depend on the, you guessed it, supply and demand for them. So what changes the supply? Answer: how many bonds the Fed's taken off the market by buying to this point, not how many bonds it's buying at this point. Quantitative easing, in other words, keeps pushing bond prices up and interest rates down even after it's done.
But rates are also low because of Europe's descent into a Japanese-style lost decade. It's simple math. Would you rather get paid 1.8 percent by the U.S. or 0.3 percent by Germany or, for that matter, pay Switzerland 0.3 percent for the privilege of lending to them for the next 10 years? That's about as easy as it gets, and it's easy even if U.S. yields keep falling to 1.7 or 1.6 or 1.5 percent. Especially when the dollar is rising against the euro, and should for awhile. Although it's not just Europe. Russia is imploding, Brazil is struggling, and, most importantly, even China is slowing down. The U.S. is now the brightest spot in what's suddenly become a pretty dull global picture, which means a lot of money that gone overseas looking for yield is coming back—and into Treasury bonds.
The reality is, inverted yield curve or not, the U.S. recovery still has a long way to go. Indeed, the economy is actually speeding up, and should continue to do so. It's not just that we're adding more jobs than before. It's that households have less debt and more money to spend now that oil prices have fallen so far. That newly-employed young people should start moving out of their parents' basements—yes, some stereotypes are true—and make us start building again. And that, even if the Fed starts hiking this year, interest rates should be at what are still historic lows for a long time to come. If anything, growth should pick up to around 3 percent a year, which by the sorry standards of this recovery, will feel like a relative boom. It's really hard, impossible even, to see where a recession would come from anytime soon, with the usual caveat that a europocalypse could change that fast.
Clinton adviser James Carville once said that he "used to believe if there was reincarnation" that he "would like to come back as the bond market" since "you can intimidate everybody." But you shouldn't let it intimidate you now. Every piece of economic data says it's at least early morning in America, no matter what the bond market might think.