The flip side of the previous point is that if the term premium narrows, yield curve inversions will become more likely even if there is no increased risk of recession. And, indeed, there is reason to believe the term premium has fallen. Recently, the ACM model’s estimates of the term premium have moved persistently lower. The average values since 2006 and 2012 are 0.77 and 0.20, respectively. (See Figure 2).3
Two authors of this Economic Brief (Wissuchek and Wolman) recently evaluated how changes in the term premium affect the likely frequency of yield curve inversions.4 In principle, one could do this by conducting a statistical analysis of historical data to assess the relationship between the level of the term premium and the frequency of yield curve inversions. However, the number of inversions is too small to produce a reliable estimate using this method. Instead, Wissuchek and Wolman’s exercise involved simulating data for the short-term interest rate and then measuring how the frequency of yield curve inversions in the simulated data varies with the behavior of the term premium.
To build intuition for this simulation exercise, Figure 3 illustrates the qualitative relationship that would arise between the frequency of yield curve inversions and the level of the term premium if the term premium were fixed at different levels. For very high values of the term premium, the yield curve would never be inverted because the expected decrease in short-term rates would never be large enough to outweigh the term premium. Conversely, for very low (negative) values of the term premium, the yield curve would always be inverted because the expected increase in short-term rates would never be large enough to outweigh the term premium. And, if the term premium were fixed at zero, then over long periods the yield curve would be inverted roughly half the time. In reality, the term premium is not constant, so the simulation involves looking at how the frequency of yield curve inversion varies as the distribution of the term premium changes.
One of the most predictable outcomes of an inverted yield curve is the discussion about whether it will be a predicative tool on this occasion because so many mitigating factors have arisen since the last inversion to suggest this time is different.
What I find particularly interesting on this occasion is other Fed economists are coming out with alternative measures which support the view we are looking at an impending recession even while they contend the yield curve spread is an imperfect measure.Click HERE to subscribe to Fuller Treacy Money Back to top