Some Words of Caution About the 2/10 Spread

I wanted to say a few words about the 2/10 spread. As long-time readers know, I’m a fan of this indicator, but the 2/10 has gotten a lot of attention recently since it’s been narrowing.

That’s why I wanted to add a few notes of caution. Let me explain how the world looks through the world of economic stats.

Lagging indicators: Sure, we got plenty of those.

Coincident indicators: Eh, a few.

Leading indicators: Not much.

The 2/10 is one. As the saying goes, it’s hard to make predictions, especially about the future.

With the 2/10, we gain a rare example of a forward indicator with a decent track record but it comes at the expense of timing. To put it in clearer words, the world doesn’t automatically explode once the 2/10 gets inverted.

The key here is that the 2/10 isn’t bad news itself. The world of finance loves to fetishize numbers. Instead, we should focus on what those numbers represent. An inverted 2/10 spread is basically like all the fire trucks being down at Arby’s having lunch. When trouble does come—and it will—the response will be more difficult.

Let’s look at some history. In December 1988, the 2/10 inverted more than 18 months ahead of the recession.

In May 1998, the 2/10 briefly inverted. It fought that off, but became inverted again in February 2000. The recession began a year later.

During the last recession, the 2/10 spread first inverted in December 2005, but the recession didn’t begin for another two years.

Still, that track record beats a lot of humans. Remember that all metrics have downsides. That’s not a reason to dismiss them. It means we have to be aware of the limitations of our analytical tools.

Posted by on December 6th, 2017 at 11:07 am

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