PREDICTING THE MARKETS

The Yield Curve:

What Is It
Really Predicting?

Edward Yardeni
Melissa Tagg

YRI PRESS

Edward Yardeni is President of Yardeni Research, Inc.

Melissa Tagg is a Senior Economist at the firm.
Predicting the Markets Topical Study #1:
The Yield Curve: What Is It Really Predicting?

Copyright © 2019 Edward Yardeni

All rights reserved. No part of this publication may be reproduced

in any form or by any electronic or mechanical means, including
information storage and retrieval systems, without permission in
writing from the publisher, except by reviewers, who may quote
brief passages in a review.

ISBN: 978-1-948025-02-7 (eBook)

ISBN: 978-1-948025-03-4 (paperback)

The authors have taken all reasonable steps to provide accurate

information in this publication. However, no representation or
warranty is made as to the fairness, accuracy, completeness, or
correctness of the information and opinions contained herein. Over
time, the statements made in this publication may no longer be
accurate, true, or otherwise correct. Over time, the authors’ opinions
as articulated in this publication may change. This publication
should not be relied on for investment, accounting, legal, or other
professional advice. If readers desire such advice, they should
consult with a qualified professional. Nothing in this publication—
including predictions, forecasts, and estimates for all markets—
should be construed as recommendations to buy, sell, or hold any
security, including mutual funds, futures contracts, exchange-traded
funds, or any other financial instruments.

Published by YRI Press, a division of Yardeni Research, Inc.

68 Wheatley Road, Suite 1100
Brookville, New York 11545

Contact us: [email protected]

 A Note to Readers
These Topical Studies examine issues
discussed in my book, Predicting the Markets:
A Professional Autobiography (2018), in greater
detail and on a more current basis.

The charts included at the end

of this study were current as of May 2019.
Updates (in color) are available at
www.yardeni.com/studies

Institutional investors are welcome

to sign up for our research service on a
four-week complimentary basis at
www.yardeni.com/trial-registration
 Introduction
Is the flattening yield curve predicting a recession? In
our opinion, the yield curve, first and foremost, predicts
the Fed policy cycle rather than the business cycle. Our
research confirms this conclusion, as does a recent Fed
study. More specifically, inverted yield curves don’t
cause recessions. Instead, they provide a useful market
signal that monetary policy is too tight and risks trig-
gering a financial crisis, which can quickly turn into a
credit crunch causing a recession. If so, then the Fed’s
recent decision to be patient and pause its rate-hiking
may reduce the chances of a recession.
In my recent book Predicting the Markets, I wrote: “The
Yield Curve Model is based on investors’ expectations
of how the Fed will respond to inflation. It is more prac-
tical for predicting interest rates than is the Inflation
Premium Model. It makes sense that the federal funds
rate depends mostly on the Fed’s inflation outlook, and
that all the other yields to the right of this rate on the
yield curve are determined by investors’ expectations
for the Fed policy cycle.” (See Appendix 1: Primer on
the Yield Curve for a fuller excerpt on this subject from
my book.)
2 THE YIELD CURVE:

Subsequent research by Melissa and myself has

confirmed this conclusion, as discussed in this Topical
Study. More specifically, after studying the relation-
ship between the yield curve and the monetary, credit,
and business cycles, we have concluded that it is credit
crunches—not an inverted yield curve and not aging
economic expansions—that cause recessions. The yield
curve is just keeping score on how the Fed is reacting to
and influencing these cycles. So why do inverted yield
curves have such a good track record of calling reces-
sions, and could it be different this time?
On Friday, March 22, 2019, the stock market freaked
out when the yield curve inverted (Fig. 1). The yield
curve did so ever so slightly, as the 10-year US Treasury
bond yield fell to 2.44%, just 2 basis points below the
three-month T-bill rate; but it was still 7 basis points
above the federal funds rate (Fig. 2). That raised fears
of a recession, reinforced by some weak Purchasing
Managers Index data out of Europe (Fig. 3).
We didn’t freak out because we aren’t convinced
that the fixed-income markets are unambiguously sig-
naling that a recession is coming, especially given the
narrowing of credit-quality yield spreads. For example,
the yield spread between the high-yield and the 10-year
Treasury bond continued to narrow from a recent peak
of 530 basis points on January 3 to 379 basis points on
Thursday, March 21 (Fig. 4).
WHAT IS IT REALLY PREDICTING? 3

During 2018, there was lots of chatter about the

10-year bond yield possibly rising toward 4.00% or even
5.00% because of Trump’s deficit-widening tax cuts and
the Fed’s anticipated “normalization” of monetary pol-
icy. Some commentators warned that when the yield
rose above 3.00%, that could spell trouble for stocks.
The yield moved decisively above that level on
September 18, 2018 (Fig. 5). A sharp correction in the
stock market ensued, with the S&P 500 dropping 19.8%
from September 20 through December 24. Now that the
bond yield is down around 2.40%, the new worry is that
such a low yield might be a bad omen for the economy
and stocks, especially since the yield curve has flattened
so much since late last year. In what follows, we consid-
er some reasons not to freak out about the yield curve.

Leading Indicator
The yield-curve spread between the 10-year US Treasury
bond yield and the federal funds rate is only one of
the 10 components of the monthly Index of Leading
Economic Indicators (LEI). The index is compiled by
The Conference Board, which added the difference
between the 10-year Treasury note yield and the federal
funds rate to the LEI in 1996 in a revision that also delet-
ed two components of the LEI, the change in the index
4 THE YIELD CURVE:

of sensitive materials prices and the change in manufac-

turers’ unfilled orders for durable goods.1 This spread
fell to two basis points on March 28, remaining slight-
ly positive. Though it is down from last year’s peak of
about 150 basis points in February, it doesn’t actually
weigh on the LEI until it turns negative.
The LEI edged up 0.2% during February (Fig. 6). It’s
been essentially flat for the past five months, though it
is still on an uptrend. At a record high is the Index of
Coincident Economic Indicators. It was up 2.5% year
over year during February, suggesting that real GDP is
growing by at least that pace (Fig. 7).
Prior to the last seven recessions, the yield curve
inverted with a lead time of 55 weeks on average, in a
range of 40-77 weeks (Fig. 8). It gave a few false, though
short-lived, signals along the way, during the 1980s and
1990s. For example, during the longest economic expan-
sion to date, the yield curve turned negative a couple of
times in 1995 and again in 1998. The recession started
a few years later, in March 2001. The signal seems to

1 See The New Treatment of the Yield Spread in the TCB Composite
Index of Leading Indicators, Conference Board 2005 report: “In con-
clusion, the transition to using the cumulative yield spread is sup-
ported by both theoretical reasons and empirical evidence. Theory
suggests that the yield curve should contribute negatively to the
LEI when it inverts, not just when it is declining. The cumulative
yield spread successfully captures this property. In practice, the
cumulative yield spread is smoother and is a better leading indica-
tor than its raw form.
WHAT IS IT REALLY PREDICTING? 5

work better as a recession indicator the longer the curve

has been inverted. It hasn’t been negative so far through
early April.
The S&P 500 stock price index is also one of the 10
components of the LEI. Not surprisingly, therefore, the
yield curve tends to start inverting at the same time as
a bear market in stocks begins (Fig. 9). If the yield curve
inverts more decisively and if the stock market heads
lower, we might become concerned about an impend-
ing recession. We don’t expect to have to do so anytime
soon.

Monetary Policy Cycle

The yield curve tends to increasingly flatten, then invert
during periods when the Fed is raising the federal funds
rate (Fig. 10). That makes sense, since rising short-term
rates increasingly raise the odds of a recession, which
makes Treasury bonds increasingly attractive.
Just before the Fed starts lowering the federal funds
rate is when the yield-curve spread is most negative;
it starts moving toward positive territory as the Fed
lowers interest rates faster than bond yields are falling.
Once it starts ascending again, the yield curve’s slope
tends to steepen as the Fed stops lowering the federal
funds rate and starts to slowly raise it again.
6 THE YIELD CURVE:

Where are we now in the monetary policy cycle? The

tightening phase may be over for a while. This may be a
pause before the Fed moves again later this year or not
until next year, and with only one rate hike, if the Fed’s
latest forecast is on the money (though its forecasts
haven’t been in quite some time). Or, the Fed may be
in the early phase of another easing cycle. Either way,
the yield-curve spread may stay right around zero for
a while, without clearly signaling a recession as widely
feared.

Boom-Bust Cycle
In the past, the Fed would raise the federal funds rate
during economic booms to stop an acceleration of infla-
tion. Fed officials did so aggressively, perhaps in no
small measure to shore up their credibility as inflation
fighters. Tightening monetary conditions often trig-
gered a credit crunch—particularly during the 1960s
and 1970s, when interest-rate ceilings on bank deposits
were set by Regulation Q—as even the credit-worthiest
of borrowers found that bankers were less willing and
able to lend them money.
Sensing this mounting stress in the credit markets
and expecting the credit crunch to cause a recession
and a bear market in stocks, investors would pile into
WHAT IS IT REALLY PREDICTING? 7

Treasury bonds. The yield curve inverted, accurately

anticipating the increasingly obvious chain of events
that ensued—i.e., rising interest rates triggered a credit
crisis, which led to a widespread credit crunch and a
recession, causing the Fed to lower short-term interest
rates.
So how can we explain the flattening of the yield
curve during the current business cycle? Inflation
remains relatively subdued, around the Fed’s 2.0%
target (measured by the personal consumption expen-
ditures deflator excluding food and energy on a year-
over-year basis). It rose to that pace during May 2018
for the first time since the target was explicitly estab-
lished by the Fed on January 25, 2012 (Fig. 11).
The Fed has gradually been raising the federal funds
rate since late 2015, yet few critics charge that the Fed is
behind the curve on inflation and needs to raise inter-
est rates more aggressively. The economy is performing
well, but there are few signs of an inflationary boom or
major speculative excesses that require a more forceful
normalization of monetary policy, which might trigger
a recession.
8 THE YIELD CURVE:

Credit Cycle
Notwithstanding the previous false alarms (including
the most recent flattening of the yield curve), the ques-
tion of why the yield curve has consistently inverted
prior to recessions remains. One widely held view is
that banks stop lending when the rates they pay in the
money markets on their deposits and their borrowings
exceed the rates they charge on the loans they make
to businesses and households. So an inverted yield
curve heralds a credit crunch, which inevitably causes
a recession.
In a December 5, 2018 post on Eaton Vance’s Advisory
Blog, Andrew Szczurowski convincingly argued that
“the market is looking at the wrong curve. It’s not an
inverted 2s-10s, or 2s-30s, or 2s-5s curve that matters.
What really matters, in my mind, is what is happening
to the curves at banks.” He observed: “At the same time,
the rates banks are charging for a mortgage are up 150
basis points from their lows. This is the first hiking cycle
where banks’ margins are actually increasing as the Fed
is hiking rates. The reason being, they aren’t paying
their depositors much more today than they were over
the past few years.”
So what really matters is the net interest margin of
the banks. Consider the following:
WHAT IS IT REALLY PREDICTING? 9

• Net interest margin. The widely held notion that a

flat or an inverted yield curve causes banks to stop
lending doesn’t make much sense. The net interest
margin, which is reported quarterly by the Federal
Deposit Insurance Corporation (FDIC), has been
solidly positive for banks since the start of the data
in 1984 (Fig. 12). The net interest income of FDIC-
insured institutions rose to a record $140.2 billion
during the fourth quarter of 2018.
• Charge-offs and dividends. There’s no sign of dis-
tress, or even stress, in the FDIC data. Net charge-
offs have been relatively stable around $10 billion
per quarter for the past few years. Provisions for
loan losses have matched the charge-offs. Cash divi-
dends rose to a record $52.7 billion during the fourth
quarter of 2018.
• Business loans. Inverted yield curves tend to
be associated with periods of monetary tighten-
ing, which often trigger financial crises and credit
crunches. There’s certainly no credit crunch today.
Short-term business credit rose to a record high
during the March 13 week (Fig. 13).
10 THE YIELD CURVE:

Global Perspective
The US bond market has become more globalized. It
is not driven exclusively by the US business cycle and
Fed policies. The rate of inflation is low not only in the
US but also around the world. However, evidence of an
economic slowdown is more apparent in other parts of
the world than in the US.
The European Central Bank (ECB) first lowered its
official deposit rate to below zero on June 5, 2014. The
Bank of Japan (BOJ) lowered its official rate to below
zero on January 29, 2016. Those rates, which remain
slightly below zero, have reduced 10-year government
bond yields to around zero in both Germany and Japan
since 2015.
The negative-interest-rate policies of the ECB and
BOJ have been major contributors to the flattening of the
US yield curve, in our opinion. Low global yields make
comparable US Treasury bonds attractive to investors,
especially when investors turn to a risk-off mode (Fig.
14). Perhaps the flattening of the US yield curve reflects
that the world is flat.
WHAT IS IT REALLY PREDICTING? 11

Bond Vigilantes
There’s a close correlation between the 10-year US
Treasury bond yield and the growth rate of nominal
GDP on a year-over-year basis (Fig. 15 and Fig. 16). The
former has always traded in the same neighborhood as
the latter. In my book, I call this relationship the “Bond
Vigilantes Model.” The challenge is to explain why the
two variables aren’t identical at any point or period in
time. Nominal GDP rose 5.2% during the fourth quarter
of 2018. Yet the US bond yield is below 3.00%.
During the 1960s and 1970s, bond investors weren’t
very vigilant about inflation and consistently pur-
chased bonds at yields below the nominal GDP growth
rate. They suffered significant losses. During the 1980s
and 1990s, they turned into inflation- fighting Bond
Vigilantes, keeping bond yields above nominal GDP
growth.
Since the Great Recession of 2008, the Wild Bunch has
been held in check by the major central banks, which
have had near-zero interest-rate policies and massive
quantitative easing programs that have swelled their
balance sheets with bonds. Meanwhile, powerful struc-
tural forces have kept a lid on inflation—all the more
reason for the Bond Vigilantes to have relaxed their
guard.
12 THE YIELD CURVE:

As noted above, a global perspective certainly helps

to explain why the US bond yield is well below nomi-
nal GDP growth. So this time may be different than in
the past for the bond market, which has become more
globalized and influenced by the monetary policies not
only of the Fed but also of the other major central banks.

Fed Study
According to a July 2018 Fed note, the probability of a
recession at that time was around 14% based on a yield-
curve model. However, a February 2019 update study
reported that the odds had risen to 50%. That recession
warning might have contributed to the Fed’s remark-
able pivot from a hawkish to a dovish stance on mon-
etary policy since the start of this year. However, the
warning was hedged considerably. Let’s have a close
look at this important study:
• Original note. The minutes of the June 12-13 FOMC
meeting offered a reason not to worry about the flat-
tening yield curve. During the meeting, Fed staff
presented an alternative “indicator of the likelihood
of recession” based on research explained in a 6/28
FEDS Notes titled “(Don’t Fear) The Yield Curve” by
two Fed economists, Eric C. Engstrom and Steven A.
WHAT IS IT REALLY PREDICTING? 13

Sharpe. In brief, they questioned why a “long-term

spread” between the 10-year and 2-year Treasury
notes should have much power to predict immi-
nent recessions. As an alternative, they devised a
0- to 6-quarter “near-term forward spread” based
on the spread between the current level of the fed-
eral funds rate and the expected federal funds rate
several quarters ahead, derived from futures market
prices (Fig. 17).
The note’s authors stressed that the long-term
spread reflects the near-term spread, and the near-
term spread, they argued, makes more sense as an
indicator of a near-term recession, i.e., one that is
expected to occur within the next few quarters. They
also observe that an inversion of either yield spread
does not mean that the spread causes recessions.
Their conclusion back then was that “the market
is putting fairly low odds on a rate cut over the next
four quarters,” i.e., 14.1% (Fig. 18). “Unlike far-term
yield spreads, the near-term forward spread has
not been trending down in recent years, and sur-
vey-based measures of longer-term expectations for
short term interest rates show no sign of an expected
inversion.”
• Updated study. The updated, February 2019 version
of the Fed study is titled: “The Near-Term Forward
Yield Spread as a Leading Indicator: A Less Distorted
14 THE YIELD CURVE:

Mirror.” Engstrom and Sharpe observed that their

near-term spread “can be interpreted as a measure
of the market’s expectations for the near-term trajec-
tory of conventional monetary policy rates.”
In addition, they reported: “Its predictive pow-
er suggests that, when market participants expect-
ed—and priced in—a monetary policy easing over
the subsequent year and a half, a recession” was
likely forthcoming. The near-term spread “predicts
four-quarter GDP growth with greater accuracy
than survey consensus forecasts. Furthermore, “it
has substantial predictive power for stock returns,”
found the Fed economists. In contrast, yields on
bonds “maturing beyond 6-8 quarters are shown
to have no added value for forecasting either reces-
sions, GDP growth, or stock returns.”
• A highly hedged warning. Buried on page 7 of
the new study is a warning that the probability of
a recession based on the near-term forward yield
spread had increased significantly since the original
study was done about a year ago: “As of the end of
the sample period in early 2019 (and the time of this
writing), the near-term forward spreads forecasted
a substantially elevated probability of a recession.”
Indeed, Figure 3 in the study clearly shows that it
jumped to 50% (based on limited first-quarter 2019
data, available only through January). Interestingly,
WHAT IS IT REALLY PREDICTING? 15

this important update wasn’t mentioned in the sum-

mary paragraph at the beginning of the study. In
any event, the charts in the paper showed that the
odds of a recession jump most significantly when
the near-term forward spread is markedly below
zero, which it was not as of the most recent analysis.
Accordingly, we’re not freaking out about an
impending recession. We are focusing on the idea
I discussed in my book, and confirmed in the Fed
study, that the yield curve first and foremost is
predicting the outlook for monetary policy, not for
recession. For example, the Fed paper noted that
“the near-term forward spread would tend to turn
negative when investors decide that the Fed is like-
ly to soon switch from a tightening to an easing
stance.”
As noted above, the yield-curve spread tends to
narrow during periods when the Fed is raising the
federal funds rate. It tends to bottom and then wid-
en when the Fed starts to lower interest rates. It just
so happens that past recessions occurred after the
yield curve inverted, i.e., at the tail end of monetary
tightening cycles.
It might be different this time, if the Fed has
paused on a timely basis from raising interest rates
any further, thus reducing the chances of a reces-
sion. After all, there’s no need to overdo tightening
16 THE YIELD CURVE:

given that inflation and speculative excesses remain

subdued. In the past, Fed tightening (not inverted
yield curves that coincided with tightening) led to
financial crises, which morphed into widespread
credit crunches, resulting in recessions (Fig. 19).
Hence, our conclusion that it is credit crunches
that cause recessions, not inverted yield curves and
not aging expansions.
• False positive signal. Drawing parallels between
monetary policy in 1998 and today, Engstrom’s and
Sharpe’s paper stated: “The most prominent false
positive during our sample came with the anticipat-
ed easing triggered by the spread of the Asian finan-
cial crises in 1998, which did not result in a recession
in the U.S. It is not hard to imagine that similar sce-
narios could generate additional false positives in
the future. The near-inversion of the near term for-
ward spread at the end of 2018 seems to have been
associated with market perceptions of significant
risks to the global economic outlook, including the
threat of escalating trade disputes. Whether those
risks manifest in a recession remains to be seen.”
More reason to believe the yield curve’s credibility
as a reliable recession predictor has been overblown.
WHAT IS IT REALLY PREDICTING? 17

Predicting the Fed

As explained above, the yield-curve spread first and
foremost is predicting monetary policy. The Fed study
confirms that point and convincingly observes that it
makes more sense to focus on the shape of the yield
curve over the next six quarters rather than over the
next 10 years for insights into the fixed-income market’s
outlook for monetary policy. In this spirit, let’s review
the market’s latest divinations:
• Missing in action. The Fed study notes: “We define
the near-term forward spread on any given day
as the difference between the implied interest rate
expected on a three-month Treasury bill six quar-
ters ahead and the current yield on a three- month
Treasury bill.”
According to Haver Analytics (our data vendor):
“We had been in touch with the Board about the
0-to-6 Quarter Forward Spread earlier this year and
they had told us they calculated it using an inter-
nal fitted zero coupon curve in quarterly maturities.
They only make annual maturities available now, so
we cannot calculate.”
• The two-year yield curve. So instead of trying to
calculate the Fed study’s near-term spread, we will
focus on the 12-month forward futures for the feder-
al funds rate, which is available daily (Fig. 20). The
18 THE YIELD CURVE:

two-year US Treasury note yield tracks this series

very closely, suggesting that it is also a good proxy
for the market’s prediction of the federal funds rate
a year from now.
• Pause prediction. After all that work, the conclu-
sion is obvious: The Fed isn’t likely to be raising
the federal funds rate over the next 12 months. On
March 28, the 12-month forward rate was 2.05%, 33
basis points below the 2.38% mid-point of the fed-
eral funds rate target range. On the same day, the
two-year Treasury note was 2.23%, 15 basis points
below the mid-point.
The Fed study suggests to us that the spread
between the two-year Treasury yield and the feder-
al funds rate may be the simplest way to track the
fixed-income market’s outlook for monetary policy
over the next 52 weeks (Fig._21 and Fig. 22). Anyone
can do this at home. But that doesn’t mean that the
market will be right, as evidenced by how wrong it
turned out to be last year.

Bottom Line
The shape of the yield curve may provide useful mar-
ket signals for Fed officials to consider when they are
deciding on the course of monetary policy:
WHAT IS IT REALLY PREDICTING? 19

• A widening yield-curve suggests that the Fed can

tighten monetary policy if necessary without risking
a recession.
• A flattening yield curve suggests that the pace of
rate-hiking should be slowed, while a flat yield curve
might be a good signal for the Fed to pause tighten-
ing for a while.
• An inverted yield curve indicates that monetary
conditions are too tight and that easing might be in
order.

For now, we still don’t see a significant risk of a reces-

sion on the horizon, especially since the FOMC recently
switched from a gradual pace of rate hikes to a patient
approach. The committee’s decision in March to pause
hiking the federal funds rate, possibly over the rest of
this year, reduces the risks of a credit crunch and a reces-
sion. That’s the current message from the yield curve.
 Appendix 1
Primer on the Yield Curve
Reproduced from
Predicting the Markets: A Professional Autobiography
Edward Yardeni

THE YIELD CURVE Model is more fun and potentially

more useful (and profitable) than the Inflation Premium
Model. It posits that bond yields are determined by
expectations for short-term interest rates over the matu-
rity of the bond. These expectations are embedded in
the “term structure of interest rates,” as reflected in the
shape of the yield curve.
The yield curve is simply a table showing the yield
on various-maturity US Treasuries at any point in time.
When shown as a chart at a point in time, it usually con-
nects the market yields of the three-month, six- month,
and 12-month Treasury bills, the two-year and five-year
notes, and the 10-year and 30-year bonds at that time.
The so-called “short end” of the yield curve tends to be
very sensitive to actual and expected short-term chang-
es in the federal funds rate. The “long end” of the curve
can be more or less sensitive to such changes, depend-
ing on longer-term expectations for the federal funds
rate.
22 THE YIELD CURVE:

The slope of the yield curve reflects the “term struc-

ture” of interest rates. Think of the 10-year yield as
reflecting the current one-year bill rate and expectations
for that rate over the next nine years. The one-year bill
rate reflects the current six-month bill rate and expecta-
tions for the six-month bill rate six months from now.
Of course, there are plenty of other combinations of
shorter-term rates and expectations about them that are
reflected in longer-term rates.
Over time, the overall slope of the yield curve is typ-
ically measured as the difference between the 10-year
yield and the federal funds rate. As I observe in Chapter
5, this spread is one of the components of the Index of
Leading Economic Indicators (LEI). Let’s look at this
business cycle indicator in the context of forecasting the
interest-rate cycle:
• An ascending yield curve indicates that investors
expect short-term interest rates to rise over time; they
demand higher rates for tying their money up longer
with long-maturing bonds. So a positive yield curve
spread implies market expectations of rising interest
rates.
• A flat yield curve suggests that investors expect
short-term rates to remain stable for the future. For
example, today’s six-month Treasury bill rate should
be the same as today’s three-month Treasury bill rate
if the latter is expected to be unchanged three months
from now, and so on all along the maturity spectrum
WHAT IS IT REALLY PREDICTING? 23

of the yield curve. At times, the Fed has raised the

federal funds rate sharply, yet bond yields didn’t rise
as much as rates on bills and notes. Such flattening
of the yield curve tended to happen when investors
expected that the tightening of monetary policy was
likely to cause a recession and bring down inflation.
• An “inverted” yield curve has a downward slope,
suggesting that investors are scrambling to lock in
longterm yields before they fall. The yield curve
spread is negative. This typically happens when
short- term rates soar above bond yields as the Fed
tightens monetary policy to fight inflation. An invert-
ed yield curve suggests that investors believe this
will cause a recession, with short-term interest rates
heading back down below bond yields. They expect
locked-in yields to exceed the short-term interest
rates during most of the investment horizon. The
yield curve might then invert, with short-term rates
rising above long-term rates as investors become
more convinced that rising short-term rates will
cause an economic downturn, prompting the Fed to
yank the federal funds rate back down. Then, short-
term rates will drop back below long-term rates, and
the yield curve once again will signal better econom-
ic times ahead.

In the years prior to my career, the yield curve was a

very useful tool for those forecasting the business cycle.
24 THE YIELD CURVE:

During the 1960s and 1970s, the financial markets were

highly regulated. For example, the Fed’s Regulation Q
allowed the central bank to set ceilings on interest rates
paid on deposits by commercial banks and by S&Ls.
When the Fed raised the federal funds rate to slow the
economy and bring down inflation, it all happened rap-
idly once money- market interest rates rose above the
Regulation Q ceilings. That’s because money poured
out of deposits and into money-market instruments.
The process is called “disintermediation,” as I note
in previous chapters. Its consequence is a credit crunch,
which [Henry] Kaufman well understood. Financial
intermediaries facing deposit outflows would stop
extending credit to consumers, homebuyers, and busi-
nesses. Kaufman believed that these credit crunches
and the busts they caused were necessary from time
to time to eliminate the financial excesses that always
occur during booms.
From that perspective, Regulation Q was a very use-
ful and effective way for the Fed to put an end to booms.
However, banks hated disintermediation and the pub-
lic hated credit crunches, so political pressure led to a
wave of financial market deregulation. Regulation Q
deposit ceilings were phased out from 1981 to 1986 by
the Depository Institutions Deregulation and Monetary
Control Act of 1980, as Chapters 1 and 8 discuss.
WHAT IS IT REALLY PREDICTING? 25

Nevertheless, the yield curve continued to work

as a business-cycle indicator. The spread between the
10- year Treasury bond yield and the federal funds
rate has been one of the components of the LEI since
1996. For many years, the index reflected the month-to-
month changes in the spread. So if the spread widened,
that would contribute positively to the LEI, pulling
the index higher, and if it narrowed, the spread’s con-
tribution would be negative, pulling the index lower.
During 2005, the spread’s contribution was changed to
put more weight on whether it was positive or negative.
That way, the spread contributes positively (negative-
ly) to LEI only when it is itself positive (negative), not
when it rises (falls). The Conference Board, which com-
piles the LEI every month, cumulates the spread month
by month.
Since the Great Recession of 2008, the Fed and other
central banks have played a much bigger role in influ-
encing bond yields. They’ve always had a big impact
on the long end of the yield curve since they have a big
influence on expectations about the course of short-term
rates. What changed is that they started buying bonds
often and in size through their various QE programs.
The credit markets clearly are very efficient and com-
petitive. They are free markets and remain less regulat-
ed now than they were in the 1960s and 1970s. However,
the central banks (a.k.a. “central monetary planners”)
26 THE YIELD CURVE:

have become the biggest buyers in the bond market in

recent years. In other words, the free markets for cred-
it are hardly free of the influence of the central banks.
This means that the central banks may be distorting the
viability of the yield curve as a business-cycle indicator.
Nevertheless, if and when the yield curve inverts
again, it will still get my attention as a warning signal that
something isn’t right with the economy. Pessimistically
inclined prognosticators undoubtedly will warn that a
recession is imminent.
In this Yield Curve Model, inflation matters a great
deal to markets because it matters to the central bank.
Investors have learned to anticipate how the Fed’s infla-
tionary expectations might drive short-term interest
rates, and to determine yields on bonds accordingly. So
the measure of inflationary expectations deduced from
the yield spread between the Treasury bond and the
TIPS might very well reflect not only the expectations of
borrowers and lenders but also their assessment of the
expectations and the likely response of Fed officials! The
data are very supportive of these relationships among
inflation, the Fed policy cycle, and the bond yield.
The Fed policy cycle is easy to depict. Tightening
occurs from a cyclical trough to a cyclical peak in the
federal funds rate. Easing occurs between the peaks and
the troughs. Not surprisingly, since 1960, tightening has
occurred during periods of rising inflation, while easing
WHAT IS IT REALLY PREDICTING? 27

has occurred during periods of falling inflation or rela-

tively low and stable inflation. Sure enough, the yield
curve spread tends to widen from its negative trough
to its positive peak during the early stage of monetary
easing. The yield curve spread tends to peak during the
late stage of monetary easing. When monetary tighten-
ing begins, the spread falls, turning less positive and
then going negative during the late stage of tightening.
The interest-rate forecasting models discussed above
aren’t mutually exclusive. All three are based on the
premise that inflation is the main driver of interest rates;
the flow of funds is a sideshow. Here’s how they differ:
• The Bond Vigilantes Model relates the bond yield to
the growth rate in nominal GDP, which reflects infla-
tion as well as the real growth of the economy. The
divergence between the nominal growth rate and the
bond yield may very well be influenced by the infla-
tionary expectations of investors as well as by their
expectations for monetary policy.
• The Inflation Premium Model is based on the infla-
tionary expectations of investors. In my opinion, it’s
not as useful to view the bond yield as some vague
hypothetical real rate plus investors’ inflation expec-
tations, unless that mumbo jumbo is influencing Fed
policymaking.
• The Yield Curve Model is based on investors’ expec-
tations of how the Fed will respond to inflation. It
28 THE YIELD CURVE:

is more practical for predicting interest rates than

is the Inflation Premium Model. It makes sense that
the federal funds rate depends mostly on the Fed’s
inflation outlook, and that all the other yields to the
right of this rate on the yield curve are determined by
investors’ expectations for the Fed policy cycle.
WHAT IS IT REALLY PREDICTING? 29

A Note to Readers
The charts included at the end
of this study were current as of May 2019.
Updates (in color) are available at
www.yardeni.com/studies

Institutional investors are welcome

to sign up for our research service on a
four-week complimentary basis at
www.yardeni.com/trial-registration
30 THE YIELD CURVE:
WHAT IS IT REALLY PREDICTING? 31
32 THE YIELD CURVE:
WHAT IS IT REALLY PREDICTING? 33
34 THE YIELD CURVE:
WHAT IS IT REALLY PREDICTING? 35
36 THE YIELD CURVE:
WHAT IS IT REALLY PREDICTING? 37
38 THE YIELD CURVE:
WHAT IS IT REALLY PREDICTING? 39
40 THE YIELD CURVE:
WHAT IS IT REALLY PREDICTING? 41
42 THE YIELD CURVE:
WHAT IS IT REALLY PREDICTING? 43
44 THE YIELD CURVE:
WHAT IS IT REALLY PREDICTING? 45
46 THE YIELD CURVE:
WHAT IS IT REALLY PREDICTING? 47
48 THE YIELD CURVE:
WHAT IS IT REALLY PREDICTING? 49
50 THE YIELD CURVE:
WHAT IS IT REALLY PREDICTING? 51