One-in-three chance yield curve inverts, S.F. Fed researcher suggests

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A flattening yield curve only slightly increases the risk of a recession, and research by the Federal Reserve Bank of San Francisco suggests a one-in-three chance the yield curve inverts by yearend.

Using a term structure model, Jens H.E. Christensen, a research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco, determined “the risk of a recession happening within the next year is slightly elevated — with around a one-in-three chance of a yield curve inversion within the next three months.”

Given the lag between a yield curve inversion and recession, he said, “this leaves a high chance that the current economic expansion will continue beyond June 2019 and become the longest in U.S. history,” Christensen wrote in an Economic Letter.

The unusual low levels of long-term Treasury yields “is reflected in the estimated model dynamics,” and several possible explanations are offered including: “declines in the risk-free or natural real rate from low productivity or an aging population,” and quantitative easing, whereby central banks bought vast amounts of long-term assets following the financial crisis.

"In either case, U.S. long-term yields may react less to increases in U.S. short-term interest rates than past experience would suggest," Christensen noted. "All else being equal, such factors would make it more likely that an inverted yield curve may not signal expectations among investors of a looming recession, unlike the assumption in this Letter. Therefore, these results should be viewed as upper bound estimates of the actual risk of a recession."

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Monetary policy Federal Reserve Bank of San Francisco
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