Review: Yield Curve Shows 60% Chance of Recession, Deutsche Bank Says

It’s human nature to try to find patterns, and then use those patterns to figure out what is going to happen next. Being able to find patterns and make connections is one of our greatest strengths. But it also gets us into trouble.

One idea that has caught on recently is that the spread between the Three Month and Ten Year US Treasury Notes can predict economic downturns, to the point of being able to put actual probabilities on the possibility of a downturn.

The article even provides a chart showing how likely a recession was through time, along with when the country actually experienced recessions. If you don’t look closely, the chart seems to back up the idea that this spread can predict downturns because the probabilities do seem to spike around recessions.

If you actually look at it (and it’s hard because the chart is pretty small, and not very clear), however, the chart doesn’t support this connection. When you dig in, there are a couple of important issues.

Based on the chart, the Treasury spread isn’t really a great forward indicator. A lot of the time, the probability of recessions hits its peak after the recession has already hit, and in one case, it seems to have peaked after the recession ended.

You also need to be able to identify which peaks are going to signal a potential recession. The chart is incredibly jagged, and there are a lot of local highs that don’t seem to be associated with recessions – and a number of those have a higher probability than some of the peaks that are associated with recessions.

What this likely illustrates is just data mining. Someone found a historical pattern that seemed to fit the data, and tried to extend it forward. While it’s nice to see that we’re dealing with probabilities rather than certainties, there’s still quite a bit of false precision here. Even if we were sure that this spread was significantly related to future downturns, could we really tell the difference between a 60% chance and a 50% chance?

All of that being said, this isn’t going to help investment performance. The possibility that this is a meaningful metric is already built into prices, because this metric has been kicking around for a while. It still comes back to focusing on the long term and staying disciplined.

For more on understanding the markets, take a look at the 12 Principles of Intelligent Investors.

 

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