"When Can Yield Curves Fail As Indicators? "

Now.
As noted in the intro to Feb. 28's Rhyme Time at the San Francisco Federal Reserve Bank: "Did the Yield Curve Flip? Will the Economy Dip?":

The curve is not yet important. We (possibly delusionally) think we'll be able to tell you when it is. 

If you think of all the wasted pixels-n-print spent on the curves over the last six months, the attention of millions of readers, time that could just as well been spent watching cat videos, it has to add up to billions of people-hours.

From Bond Economics (also on blogroll at right):

Although yield curve slopes are very effective indicators for forecasting recessions, they are not infallible. This article discusses some of the reasons why a yield curve inversion can be a misleading recession signal.

NOTE: This article is an unedited section from my manuscript on recessions. As an immediate disclaimer, this section follows one in which I lay out an explanation of why the yield curve is an effective indicator (which is a re-write of an article published earlier). This section counter-balances the enthusiasm from the previous analysis. This is not a statement of my personal views about the recent curve inversion; I remain agnostic with respect to recession odds. Much of the discussion is generic, and may not be applicable to the current U.S. situation.

Although yield curves (slopes) should be expected to be a useful recession indicator, this will not always be the case. (Once again, I will use “yield curve” as a stand-in for what are more properly termed slopes.) The explanation is that they result from fixed income pricing, and investors trade bonds in order to make money, not provide signals to economic analysts.  Anything that puts a wedge between that goal and economic outcomes clouds the signal.

One first obvious point is that bond market pricing could be completely unhinged with respect to future outcomes. We cannot expect bond market participants – and by extension, bond market pricing – to be clairvoyants. We are instead assuming that bond market participants have at least a plausible chance of making a correct prediction based on available information.

One important potential source of distortion – that cannot be corrected for by a technical discussion of bond market characteristics – is that the risk-free curve is pricing the path of the policy rate. Yield curve inversion is associated with expected rate cuts. The historical experience is that the central bank generally only cuts rates when a recession hits, but this is not always the case.

The figure above shows the experience in the United States around the 1998 crisis in the post-1990 period. (I recycled the chart I used last week, with no updates.) We will focus on the experience around the 1998 crisis. The slope from the Fed Funds rate to the 10-year yield inverted (bottom panel), and this coincided with rate cuts (top panel). Although the move was quickly reversed, bond market participants did correctly anticipate the central bank policy shift. However, the United States avoided recession (the Asian economies were plunged into a deep contraction because of currency pegs breaking, and policies pushed on them by the IMF). In other words, the market was correct about Fed policy (and hence pricing was vindicated), but there was no recession to show for it....MUCH MORE