This time is different for yield curve? They said that last time

April 3, 2019 1:28 PM

“This time is different.”

That famous line, which mutual fund legend Sir John Templeton once called “among the four most costly words in the annals of investing,” is back in fashion these days when it comes to the Treasury yield curve. Skeptics from Goldman Sachs to Morgan Stanley Investment Management say the curve’s recessionary signals may be distorted now as a result of central bank policy that’s kept interest rates exceptionally low since the financial crisis.

Is it deja vu all over again? More than a decade ago, then-Federal Reserve Chairman Ben Bernanke dismissed the curve’s predictive powers after two of the most widely watched yield spreads inverted and then went flat. In Bernanke’s camp were then-Treasury Secretary John Snow and bond king Bill Gross. And we all now what happened next. That time was famously not different.

“People may say ‘this time is different’ due to quantitative easing, but this is a signal that’s been extremely strong,” said Charles Luke, whose team manages almost $21 billion in fixed-income assets for City National Rochdale in New York. “People who are not giving as much weight to it are missing the boat.”

The fact that yields on 10-year Treasurys are now back above those on three-month bills, after spending much of last week below, should not be mistaken as an all-clear signal. That type of “mini-inversion,” lasting one to eight days, can be a precursor to a longer-term episode, according to Luke, who has analyzed the history of inversions.

A flashback to what some policymakers and investors were saying in 2006 and 2007, after the 2-year/10-year and 3-month/10-year spreads had started to flash warnings, reveals some arguments that sound similar to today’s skepticism that inversions signal an upcoming recession.

Comments from policymakers and financial titans follow. — Bloomberg News

Ben S. Bernanke, former chairman of the U.S. Federal Reserve, listens during a Hutchins Center on Fiscal and Monetary Policy event at the Brookings Institution in Washington, D.C., U.S., on Monday, Jan. 8, 2018. The event was entitled Should the Fed Stick with the 2 Percent Inflation Target or Rethink It. Photographer: Andrew Harrer/Bloomberg

Andrew Harrer/Bloomberg

‘Reality checks’

In one of his first major speeches at the helm of the Fed, Bernanke told the Economic Club of New York in March 2006 that he “would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come.” Instead, he favored using multiple sources of information, along with “frequent reality checks,” so that “we are less likely to be misled when a favored variable behaves in an unusual manner.”

Now a distinguished fellow in residence at the Brookings Institution in Washington, Bernanke declined a request last week for further comment on his 2006 remarks.

Then-Treasury secretary John Snow said in a Jan. 6, 2006, interview that “there’s no reason for great alarm” after the 2-year/10-year spread had returned to flat from an inversion the prior month.

John Snow, chairman of Cerebus Capital Management LP, speaks at the George Washington University Global Forum in New York, U.S., on Friday, Oct. 29, 2010. Snow, former secretary of the U.S. Treasury, said he sees the possibility of a double-dip recession if taxes are increased and that the U.S. economy is performing way below its potential. Photographer: Jin Lee/Bloomberg *** Local Caption *** John Snow

Jin Lee/Bloomberg

‘No reason for great alarm’

Then-Treasury Secretary Snow said in a Jan. 6, 2006, interview that “there’s no reason for great alarm” after the 2-year/10-year spread had returned to flat from an inversion the prior month.

With rates low at both the front and long end, “the yield curve under these circumstances doesn’t foretell anything ominous for the economy.”

Snow, now chairman of Cerberus Capital Management, said Tuesday that he stands by his statement.

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'I don't think I'm concerned'

Dismissals of the curve’s warning signal back then were not confined to the Washington beltway.

Bill Gross, then-manager of the world’s biggest bond fund and co-founder of Pimco, said in a January 2007 interview that the shape of the curve wasn’t as accurate a recession predictor as it once was because demand for Treasurys by foreign central banks had distorted the traditional relationship.

“I don’t think I’m concerned with it,” Gross said. “I don’t think Bernanke’s concerned with it.” Gross, who announced his retirement from Janus Henderson Group in February, did not respond to a request for comment.

‘Silliness’

Worries about an inverted 2-year/10-year curve amounted to “silliness,” Lou Crandall, chief economist of Wrightson ICAP in New York, wrote in a January 2006 note. In fact, few economists were standing by the theory that yield-curve inversions signaled a recession.

“Ouch,” Crandall said Tuesday in reaction to his own 2006 views. “Forced to choose a simple yes-or-no answer, I would say that I still take that general view — though with a little more nuance than just writing it off as ‘silliness’ in a throwaway line,” he wrote in an email. Inverted yield curves are “symptomatic” of late-cycle conditions when recessions are more likely and not “concrete” signals, he said. The decline in long-term yields over recent months “has made a recession less likely rather than more,” Crandall added.

‘Run for the exits’

Not everyone at the time agreed an inverted curve should be ignored. Inversion is “a horse with a track record we would rather not go against,” David Rosenberg (left), then-chief North American economist at Merrill Lynch, told clients in January 2006. Rosenberg is currently chief economist and strategist at Gluskin Sheff.

That same month, James F. Smith, a professor at the University of North Carolina and the U.S. bond market’s most accurate forecaster back then, was quoted as saying that “when the curve inverts, run for the exits.”

'One cannot profitably borrow'

Then, as now, some analysts pointed to the negative effect the inversion would have on banks.

“People say it’s going to be different this time because of the low level of interest rates; what that argument misses is the fact that somebody has to make money lending money,” Marc Seidner, then-director of active core strategies at Standish Mellon Asset Management, said in a January 2006 interview. “The yield curve matters because financial institutions make money by borrowing at low short-term interest rates and lending at higher long-term interest rates,” said Seidner, who is now at Pimco.

When the gap narrows, “one cannot profitably borrow short and lend long, and the incentive to do that diminishes. If there’s less borrowing activity, people aren’t investing in future growth.”

‘Intellectually inert’

Some who dismissed the yield curve last time are sticking to their guns and dismissing it again. John Silvia, then-chief economist of Wachovia, wrote an August 2006 note that called believers in the curve’s signal “intellectually inert.”

“The fact that something, at some time, precedes something else, sometime in the future, does not mean rainy days actually predict sunny days.”

Now with Dynamic Economic Strategy in Charlotte, Silvia stood by his quotes in a phone interview last week.

“I said it, I believed it, and that’s it,” Silvia said. Research he did while at Wells Fargo in the last two to three years found the curve “doesn’t add any value to the predictive power of the equation in terms of forecasting recessions. End of story.”