Double-Dip Recession? The Yield Curve Says No

While it's certainly popular to say the U.S. economy is heading toward a double-dip recession, the simple reality is that we're still in the first one that started in December 2007, as I told Portuguese economics blog Janela na web (Window on the Web) in an interview in June. That's because the National Bureau of Economic Research (NBER), which officially declares the beginnings and ends of recessions, says that the job losses that started in December 2007 are still with us.

Still, I can understand what most people are referring to when they talk about a double dip. We've had positive GDP growth since the fourth quarter of 2009, and the fear is that this growth will turn negative.

But the yield curve -- the interest rates paid on different durations of Treasury bonds -- is sloped upwards so much that the chances of such a double-dip recession are a mere 15.5%, according to the Federal Reserve Bank of Cleveland.

How The Yield Curve Predicts The Economy

The theory behind the yield curve is well-explained in William Greider's 1987 bestseller about the Federal Reserve, Secrets of The Temple. The Fed sets short-term interest rates and the market sets the longer-term ones. These differing rates over time can be depicted as a curve that either slopes up or down. If the yield curve is positive sloping -- in other words, when short-term rates are lower than long-term rates -- then the economy is likely to expand.

That's because under those conditions, banks will be rewarded by the spread between rates for borrowing money in the short-term and lending it out for later repayment. Simply put, an upward sloping yield curve makes it profitable for banks take money at a very low rate and to lend it to business and individuals who will repay it later at a higher rate. Such lending generally puts more money into the economy and leads to economic growth.

Conversely, when the Fed wants to cool off an overheated economy, it raises the short-term interest rate to the point where the yield curve slopes down -- creating a so-called inverted yield curve. When this happens, the spread I mentioned above turns negative and it is more profitable for banks to hold onto their cash.

How so? If they were to lend it out under such conditions, they would be paying a higher interest rate to attract deposits than they would receive from people to whom they lent it out. Under those conditions, rather than lose money on lending, banks will hoard their cash. That reduction in the amount of money flowing into the economy induces an economic slowdown.

What The Yield Curve's Saying Now

Today, this theory predicts an economic expansion, because, as Bloomberg reports, the gap between 2-year and 10-year Treasury notes -- the short and the longer term durations -- is 2.11 percentage points. While this spread is narrower than February 2010's record 2.91 percentage point spread, it's nearly double the average since 1990. In other words, we have a very positive yield curve now.

Bond traders note that the last seven economic contractions have been preceded by an inverted yield curve, so they're not buying the idea that a downturn is imminent. But if we're not heading into a recession, how much will the economy grow? The Cleveland Fed's projections of the three-month Treasury bill rate to 10-year note yield suggest slow, but positive economic growth -- up 1.14% over the next year.

If that turns out to be right, there won't be a double-dip, but it won't feel much like economic growth. And if that slow growth leads to a moribund job market, it may take more than a year for us to get out of the recession that NBER said started in December 2007 -- and that's still, technically, going on.