What Is The Yield Curve? Why Is It Important? 1

April 11, 2022

What Is The Yield Curve? Why Is It Important? 1

The shape of the yield curve gives us important indications of what the future holds for the economy

The mainstream media has been focused on whether or not the US yield curve indicates a looming recession, which implies that what they want to know is whether or not a recession will occur.

To them, it is a binary outcome: recession = bad for markets, and no recession = good for markets.

Unfortunately reality isn’t so simple.

Why?

Because what really matters isn’t whether or not a recession occurs, or the probability of one occurring.

It’s the depth of the recession that counts.

One way to appreciate this is to ask yourself, would you rather have a high probability of a shallow recession that’s over in a few months?

Or a low probability of a deep recession that lasts for more than a year, and has the potential to develop into a full blown economic depression?

Another perspective from which to think about this is through the concept of expected value. Mathematically, The expected value associated with probabilistic outcomes is the sum of the product of its probabilities and their payoffs.

The negative payoff that results from low probability, deep recessions, is so large that it drives the expected value below 0. This happens even though the probability of the opposite happening, i..e no recession, is much higher.

This isn’t to say that the probability of a recession doesn’t matter at all. It does, simply because the vast majority of folks would rather there not be a recession at all.

With this in mind, it is important to remember that the yield curve, in this case defined as the spread between 2y and 10y US Treasury (UST) yields, has been accurately predicting recessions since the 1970s.

Such a record deserves respect, which is why we have been tracking the flattening and inversion in the 2s10s for months in the Macro Edge.

While some mainstream commentators point out that this time could be the exception, and it could be, they are missing two broader points.

The first being, even if it turns out that this time truly is the exception, we have no way of knowing it right now.

All we have are probabilities based on what can be observed from the past, which begs the question, would you want to bet against a track record as solid as the 2s10s?

The second point is what’s stated above, that the depth of recession matters more than the probability of its occurrence.

Here, unfortunately, the yield curve does little to help us as it doesn’t indicate how serious a future recession could be.

Why is that?

To be continued…