That Trusty Yield Curve

Remember back when the yield curve was inverted -- a pretty reliable sign that rough economic times were ahead? But, you'll probably also remember the general view on Wall St. was that this time it's different.

I mean, who could've predicted a major downturn -- and possible recession -- was in the offing? (Ironically, it was the man who started it all...and the average Joe, too.)

Here's a WSJ story on the predictive power of the yield curve, written in January 2007, five months after the spread between the 10-year U.S. Treasury bond and the 3-month Treasury bill turned negative:

One economic-forecasting tool using Treasury yield-curve data pegs the chances of a recession at nearly one in two. The model, which was developed by Fed economist Jonathan Wright, takes into account yields on 10-year and three-month Treasury securities as well as the Fed's overnight funds rate.
Another forecasting model -- developed by Federal Reserve Bank of New York economists using only the 10-year/three-month spread -- puts the chances of a recession in 12 months at just under 40%.
Those predictions are at odds with the consensus among economic forecasters.
A recent survey of economists by The Wall Street Journal pegged the chances of a recession within the next 12 months at 27%.

And here's the generally accepted view, at the time, for why this time it really was different:

Two researchers who focus on recession forecasting, Lakshman Achuthan and Anirvan Banerji of the Economic Cycle Research Institute, argue that the yield curve is overrated as a recession harbinger. They note that the yield curve failed to invert before recessions in the 1950s and early 1960s. They also point to the misleading signal sent in 1966-67, when a lengthy inversion didn't precede a recession.
Messrs. Achuthan and Banerji argue that the economy and financial markets have changed greatly in recent years.
They note that pension funds, oil-producing nations and other cash-laden institutional investors around the world have been pouring money into long-term Treasurys, which they say creates "artificial" pressure that pushes long-term bond prices higher and their yields lower.

What the yield curve tells us, according to economists that have studied its predictive powers, is that when a recession does occur, an inversion happens between .5 to 1.5 years beforehand.

This time the yield curve first inverted in August of 2006 (and re-steepened in May 2007), signaling the chances for a recession would be higher between April 2007 and March 2008.

The economy has grown at a healthy clip, registering gains of 3.8 percent and 4.9 percent in the second and third quarter, respectively. But as we know, things have taken a turn for the worse, and according to the latest Survey of Professional Forecasters from the Philly Fed, economists were lowering their expectations for economic growth throughout last year.

While some Wall St. economists are saying we're in a recession now, it's worth pointing out that a yield curve inversion doesn't necessarily mean that it's a must -- which understandably gave folks like Achuthan and Banerji grounds to argue that this time it was different.

As Achuthan and Banerji point out, in 1966 the yield curve predicted a relatively high chance of a recession (37 percent or 23 percent depending on which model you look at), but none occurred.

What happened then? A little thing called a credit crunch.

UPDATE
One thing I forgot to include above is that the models predict either about a 40 percent chance or 19 percent chance of recession this time around (again depending on which one you look at). The model that spits out the lower number is the one which Joshua Rosenberg and Samuel Maurer of the New York Fed argue is the more accurate forecaster of recessions.

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