How afraid of the dreaded inverted yield curve should we be? Based on the existing evidence, not very.
PREDICTING THE NEXT RECESSION, PART 2
The yield curve plots the interest rates (or more specifically, yields) associated with bonds of varying durations to maturity. A normal yield curve rises from left to right, with longer-term rates sitting above shorter- term ones. This is intuitive: there is more risk (including that posed by inflation, which erodes the value of money) associated with an investment over 10 years than over three months, for example, and investors must be compensated for this added risk. An inverted yield curve—meaning it declines from left to right—is defined by longer- term rates falling below short-term ones, implying that investors are pessimistic about future economic prospects (this may include a view that future inflation will be very low and/or that interest rates will fall from current levels). Across the globe, inverted yield curves have time and time again preceded recessions, thereby yielding (pun intended) the widespread unease associated with currently- inverted yield curves.
In Canada, the shape of the yield curve has not, for many economists, been a reliable predictor of future economic performance despite the alarms recently sounded by the masses of self-appointed yield curve experts. In the three recessions we've had since the late-1980s/early-1990s, an inverted yield curve materialized before two of them, but not the third: the mild 2015 recession, which almost everyone missed if they blinked, was preceded by a normal yield curve. Additionally, the yield curve has inverted three other times since the mid-1980s without a recession following. Because yield curves themselves don’t cause recessions, it is useful to consider that in Canada inflation is normal, job and wage growth is robust, population (and labour force) growth is strong, and incomes are rising. While yield curve characteristics are certainly worthy of our attention, we will more closely be focusing on the true drivers to Canada’s economic performance, many of which are explored in this report.
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