The Inverted Curve and Recession: A Hoax, When Will it End?

Abstract

This paper shows that the chance that an inverted yield curve correctly predicts recession is less than 3.9%, and is not even statistically significant. For instance, on March 22nd, 2019, an inversion occurred and the Dow lost 460 points, yet, after about a month the Dow reached an all-time high. But why then do investors still see a linkage between inverted curve and recession? The behavior psychology research demonstrates that, for the majority, bad events (such as the 2007 inversion event) register stronger and longer than good events, remaining vivid in investors’ memory. During the March 22nd inversion of a few months ago, investors forgot that the yield curve has inverted many times without a subsequent recession, instead, they remembered the 2007 inversion associated with the Great Recession. Finally, we show that the strongest and best predictor for recession is the current GDP growth rate.

Quote by Marie von Ebner-Eschenbach: “Even a stopped clock is right twice a day”.

Keywords: behavioral finance, inverted curve, recession

JEL Classification: G12