- The inverted yield curve has been one of the most reliable predictors of an imminent recession.
- An inversion of short and long-term bond yields has preceded every recession since World War II.
- But the economic indicator could be less reliable due to high bank reserves, according to Ned Davis Research.
A historically reliable recession indicator began flashing red last year as the difference between long-term and short-term bond yields was flipped, but there's a reason that the closely watched signal may no longer be reliable, according to Ned Davis Research.
When short-term yields surpass longer term yields, it sends a signal to investors that the economy is on shaky footing and set to enter a downturn.
Since World War II, an inverted yield curve has always preceded an economic recession.
In July 2022, the inverted yield curve once again turned negative as the Fed continued to aggressively hike interest rates. The 2-year Treasury currently yields 4.70%, about 80 basis points more than the 10-year Treasury yield of 3.90%.
As the yield curve inversion deepens, many investors feel certain that the economy faces a recession in 2023.
But a Monday note from Ned Davis Research argues that the yield curve inversion indicator may no longer be a reliable leading indicator of a coming downturn.
That's because this time around, banks are able to avoid being the biggest losers when it comes to an inverted yield curve thanks to high amounts of deposits.
"In the old days, banks would borrow short and lend long. With an inverted curve, that's a disastrous recipe for net interest margins. Banks would tighten standards or charge more for loans," NDR's chief global macro strategist Joseph Kalish explained.
But after the Great Financial Crisis, banks were required to significantly build up their reserves, which is now helping them weather an inverted yield curve.
"In an ample reserves regime that we've been in post-GFC, banks also have plenty of deposits. They don't need to borrow in the fed funds market to meet reserve requirements. As a result, inverted curves are less effective in the transmission of financial conditions to the real economy," Kalish said.
Kalish made the point that apart from 2019, all of the yield curve inversion signals that preceded a recession occurred before the Great Financial Crisis, when banks were more dependent on short-term funding rates. But with bank borrowing down 35% from the 2008 peak, that's no longer the case.
Kalish isn't alone in his skepticism of the yield curve inversion indicator. Cam Harvey, the economist and professor who first identified the yield curve as a reliable recession indicator, thinks this time is different.
"Do I expect a recession? No. Each episode is different, and this episode is just so different," Harvey told Insider in December.