Economist: Yield curve inversion has been true, but new factors may complicate its accuracy

University of Arkansas’ Walton College economist Mervin Jebaraj admits that the yield curve inversion has been an accurate predictor of past recessions, but he warns that the current economic environment has many variables that suggest reliance on the oft-used siren should be cautious.

“I think there are a lot of yield curve evangelists out there in the world and they talk about the yield curve like it is the second coming of Christ and its predictive powers are amazing,” said Jebaraj, who appeared on this week’s edition of Talk Business & Politics.

“What is true about the yield curve is that it has correctly predicted the last few recessions. That doesn’t necessarily mean that it’s going to predict every recession in the future,” he said.

The yield curve inversion is essentially when investors shift purchases from short-term treasuries, such as bonds, to long-term treasuries because they sense that short-term investments will lose value. The long-term treasuries tend to offer lower returns, but that is considered safer from recession than short-term offerings.

“What this does is it inverts the curve where the difference between the long-term and short-term treasuries turns negative, and that’s what we call a yield curve inversion,” Jebaraj noted.

The Fayetteville economist said there are several factors that may complicate reliance on the yield curve inversion as an economic harbinger.

He said developed countries across the globe are in long-term lower growth cycles, which flattens the yield curve. Global inflation expectations are also historically low below 2%, another variable that can flatten the yield curve.

Another factor to consider, says Jebaraj, is that the Federal Reserve has a massive balance sheet that it accumulated as part of quantitative easing during the Great Recession. This pushed down long-term yields, he contends.

“They have divested some of these treasuries, but they’re stopping that process later this year, so that puts negative pressure on yields as well in the sense that the Federal Reserve holds a lot of treasuries and yields are lower,” he said.

“So, for a variety of different reasons, the long-term yields are lower that don’t have to do with people fleeing short-term for long-term [investments] because of short-term economic prospects. So, that’s not to say that we’re not likely to see a recession next year, it’s just to say that maybe the yield curve inversion stops being as good a predictor because of some other structural issues in our economy.”

Jebaraj also discussed the revisions that came to Arkansas’ employment numbers last year and the Federal Reserve’s recent moves to curtail interest rate hikes. You can watch Jebaraj’s full interview in the video below.