Okay, a short thread on why the inverted yield curve may, in fact, be different this time. Apologies in advance to @cabaum1, @IrvingSwisher, @Frances_Coppola and other yield curve enthusiasts who are wondering what "this time is different" Kool-Aid I have been drinking. (1/x)
Let me acknowledge upfront that even if the case I am going to make is correct, the inverted yield curve (YC) could still lead to a recession because of (1) self-fulling expectations and (2) the harm inflicted on financial intermediation via compressed net interest margins. (2/x)
To make the "this time is different" argument, consider first the standard theory for long term interest rates:

long term rates = average expected short term rates over the same horizon plus a term premium.

In short: LT rates = avg. exp ST rates + TP (3/x)
Consequently, the YC spread, say the 10 year minus 1 year spread, is equivalent to the following:

YC spread = 10 yr - 1 yr = [avg. exp. ST rates(10yr) - avg. exp. ST rates (1yr)] + [TP(10yr) - TP(1yr)].

This decomposition can be used to see why the YC is inverting. (4/x)
Now most say that if a yield curve inversion is caused by a declining term premium, no biggie. It is when the expected path of short-term interest rates decline we should worry. For it means the market expects the economy to weaken and pull down interest rates. (5/x)
Our YC spread decomposition outlined above can tell us whether it is changes in (1) the term premium or (2) expected path of short-term rates that is causing most of the YC inversion. (6/x)
Consider the previous YC inversion leading up to 2008 crisis. Using NY Fed data, we see that while there was some decline in the term premium, there was even more decline in the expected path of short-term interest rates. The YC inversion was sending a true warning signal. (7/x)
Now look at the current inversion using the same data. It shows the inversion is almost entirely the result of a declining term premium. This is the argument for why the YC inversion might be different this time. Maybe no recession is coming. (8/x)
Again, the YC inversion could still be followed by a recession because of self full-filling expectations & the harm it brings financial intermediation. And maybe we shouldn't put too much trust in the NY Fed data. But at a minimum it suggests a cautious YC view. The end.(9/x)
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