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Pavlov And Why One Bank Thinks This Time Is In Fact ‘Different’

The debate continues...

Reams have been written over the past six months about whether “this time is different” when it comes to a flattening/inverted yield curve presaging recession.

Generally speaking, people who engage in this debate fall into one of two camps. Those who insist the yield curve “must be respected” often rely on superficial allusions to historical precedent. The strength of that argument lies not in nuance or analytical brilliance, but rather in the fact that historically, inversions “predict” recessions – albeit on a variable lag. In the other camp are those who painstakingly recount the finer points, detailing the extent to which cycles differ and expounding on all the reasons to believe that “we’re not in Kansas” anymore after 2008. For those folks, the nuance is what matters and, in many cases, their arguments appear to be quite convincing.

Reduced to their respective common denominators, one camp uses history as a trump card, while the other camp cites ostensibly superior analysis.

This debate will never – ever – be settled, but for what it’s worth, BNP is out with some mildly interesting commentary that’s worth briefly highlighting.

The bank couches the market’s recession obsession in Pavlovian terms – literally. To wit, from a note dated Monday:

Does Pavlov’s experiment on classical conditioning hold true for the US 2s10s curve? Is a fall in global inflation expectations along with a yield curve flattening generating a conditioned response of an expected recession?

Essentially, BNP argues that the 2s10s “is responding to inflation” (or actually, to disinflation), and is thereby “not a good indicator of recession expectations at the moment”.

After recapping that over the past three decades, curve flattening has presaged recessions and subsequently lower inflation, the bank notes that today, the outlook for growth isn’t so much dire as it is “tepid”, while inflation expectations continue to recede.


“The implications are quite different for markets with soft growth and low inflation and those in recession and low inflation”, BNP goes on to write, adding that “in the first, risky assets perform well, supported by low defaults and interest rates, while in the latter risky assets perform poorly as default risk trumps interest rate support.”

At heart, this is just another way of discussing the fine line between a dovish policy pivot predicated on a tenuous growth outlook and subdued inflation on the one hand, and a dovish policy pivot predicated on panic and/or fear of imminent recession on the other. The former case is risk asset+ as central banks effectively underwrite carry trades and suppress defaults, while the latter is obviously risk asset- as a downturn ushers in a default cycle and an unwind across risk, irrespective of policy support.

The cross-asset implications are equally obvious in either alternative. That is, if you believe this time is in fact different, that the world isn’t headed towards a deep downturn and that forward guidance will continue to be deployed effectively, well then rates vol. should remain low, credit will be well supported and equities can perform. Indeed, that’s generally what BNP says in the remainder of the note.

“Fed has signaled the end of tightening at its lower bound of neutral given limited inflation pressure, lower household credit growth than previous expansions and increased focus on financial conditions (ie, asset prices)”, the bank writes, before suggesting that “with real fed funds rising more slowly and to a much lower level than historically, even adjusted for a new neutral rate” a recession isn’t likely. Instead, BNP argues that “the Fed’s dovish shift from January will take rates volatility to new structural lows as the Fed has reduced the upside (no more hikes, lower dots) and downside (early dovish pivot) distribution of rates.”

As far as credit goes, the bank cites their own US credit conditions index, noting that previous episodes of curve flattening often led credit conditions. “Recently, however, the two have deviated: the yield curve is very flat, but credit conditions appear stable”, the bank observes, adding that “this may be reflecting changes in how the US banking system matches assets and liabilities.”

Finally, on stocks, BNP echoes every other desk in reminding you that trying to time the equity market based solely on curve dynamics is a precarious exercise at best and a fool’s errand at worst. We’ve sliced and diced this every way it can be cut up in these pages, but because this is the topic du jour, it doesn’t hurt to hear it from one more bank, we suppose. Here’s a (very) short excerpt from BNP’s section on stocks versus the curve:

Is a negative yield curve necessarily bad for equities? No, in a single word. It is true that a negative US yield curve has often (but not always) predicted a subsequent US recession. However, even when true, the lag between the first occurrence of a negative yield curve and a recession can be long, typically around a year but often longer.

And so, the “Is this time different?” debate around the curve will continue to rage for the foreseeable future or at least until we discover who was “right” in this cycle.

No matter whose assessment is ultimately borne out, you can expect everyone to have the same discussion next time around with the only difference being whether the 2019 experience is counted as another confirmatory instance of inversion presaging a downturn or as an “anomaly.”


2 comments on “Pavlov And Why One Bank Thinks This Time Is In Fact ‘Different’

  1. A ton of digital ink has been spilled on this topic. A flat yield curve generally makes it harder for banks to lend, as banks are a vehicle to transform to bridge the gap between short term assets and longer term liabilities. In other words in a world of flat curves it is harder to make spread and therefore profits for a bank or other lender. A flat or inverted curve also suggests that investors believe inflation will be lower and thus are willing to lend at low rates in order to lock in yields. Such a dynamic is often a precursor to a recession, but is only a necessary condition. The sufficient condition is widening credit spreads- that is an increasing aversion to risk. When combined with a flat curve that will cause lending to be curtailed and is then transmitted into the real economy. Many times I find the discussions about this overly technical which makes the concept way harder to understand. Credit and lending is critical to a growing economy. Conditions which cause lending and risk taking to drop will directly lead to a slowing economic growth and if the magnitude of the drop is enough will cause a recession. Thinking of lending as blood flowing through an organism to keep it alive is an apt anology. Cut of the blood flow and the organism begins to decline…..

  2. PS- Credit spreads widened out in the 4q 2018 and if the Fed had not changed course this would have led to a recession. Credit spreads came in after the pivot. This is part of what economists call financial conditions. Watch credit spreads, if they start to widen again it will be a sign of trouble. Likewise if the curve does not change and credit spreads do not widen a recession is unlikely.

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