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Don’t Fear the Yield Curve

Tuesday, July 24, 2018

by Rich and Sheila Jamison

Two topics, tariffs and potential yield curve inversion, have dwarfed other economic reports and disrupted the market in recent weeks. Tariff news changes too quickly for us to hope that whatever we write now will still be true when you get to read it. However, the possibility of an inverted yield curve is fair game.

What Is an Inverted Yield Curve?

For that matter, what is a yield curve? A yield curve compares interest rates (or “yield”) for similar debt securities that have different maturities.

In a ‘normal’ (growing, expanding) economic environment, the yields for shorter-term bonds (the ‘front end’ of the curve) are less than for longer-term bonds (as you guessed, called the ‘back end’). Hence, yield curves slope upward, because the longer you hold the bond before getting your money, the more risk you face.

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There are many yield curves, as many as there are types of bonds. The one most commonly discussed compares the interest rates for 2-year and 10-year US Treasuries.

The interest rate used is the effective interest rate. That’s calculated from the current market price for the bond, which could be higher or lower than its face value.

An inverted yield curve occurs when the short-term rate exceeds the longer-term one. The curve inverts (i.e., turns ‘upside down’ and slopes downward instead of upward). This could happen if the Fed hikes the fed funds rate enough to drive short-term yields above longer-term Treasury bonds.

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Fancy Geometry, But So What?

Briefly, an inverted yield curve historically has preceded economic recessions. All nine recessions since 1955 were preceded by an inverted yield curve, albeit each occurred a year or two after the curve inverted1. That sounds scary – hence, news headlines scream it as our current yield curve gets flatter (meaning more horizontal or less sloping) and could be inverting2.

It is important to recognize “all recessions were preceded by an inverted curve” is not the same as “recessions followed all inverted curves.”

Still, an inverted yield curve is enough to create some nervousness.

Fancy Logic, But So What?

Here’s a simplified look at how our economy works. It alternates between good periods (expansions) and bad periods (recessions). We like the good ones and dislike the bad ones. Financial market investors care because the stock market typically tends to go as the economy goes! We (except ‘short sellers’) like our investments going up.

Don’t Fear the Yield Curve

The title sounds comforting, but does anyone “in the know” feel this way? We didn’t make up our title; we stole … er, borrowed … the title from a June 28, 2018 paper by Eric Engstrom and Steven Sharpe. They are members of the Board of Governors of the Federal Reserve System – you know … the people responsible for controlling interest rates.  

In fact, many Fed Governors have commented regarding our current situation. A few of these comments:

“[Although] there are good questions about what a flat yield curve or inverted yield curve does to intermediation … I don’t think that recession probabilities are particularly high right now.” Fed Chair Jerome Powell.

 “I just think long rates are going to go up given where we are in the economy and given where we see the economy going. But this is another reason why we need to keep raising up the short rate.” Loretta Mester, Cleveland Fed.

I’m not viewing the current flattening of the yield curve as much of a signal toward an impending recession.” Randal Quarles, Fed Vice Chair

 “I am not concerned about the recent flattening of the Treasury yield curve.” William Dudley, New York Fed.

 “The flattening of the yield curve that we’ve seen is so far a normal part of the process, as the Fed is raising interest rates, long rates have gone up somewhat—but it’s totally normal that the yield curve gets flatter.” John Williams, San Francisco Fed.

I’m also keeping an eye on the yield curve. I think worries so far have been a little inflated.” Pat Harker, Philadelphia Fed.

Fed officials who feel a bit less relaxed about the yield curve’s flattening generally (save Neel Kashkari) are still quite muted in their comments:

Yield curve inversion remains a possibility this year.” James Bullard, St. Louis Fed.

 “Flat yield curve tells me the bond market sees sluggish growth.” Robert Kaplan, Dallas Fed.

Neel Kashkari (Minneapolis Fed) is the most concerned by the flattening curve. He has called it “a yellow light flashing” – taking it as a warning to stop increasing rates or risk slowing the economy too swiftly and bringing on a recession.

Two Key Points

First, the Federal Reserve’s influence normally is greater on the front end of the curve (short-term rates). The bond market’s economic expectations dictate rates on the back end (longer-term rates).3

However, past inversions occurred when governments were not holding the plethora of bonds they hold now. Remember, when bonds are “on sale” (price going down) it means rates are going up. The Fed has so many of the longer term bonds now that they have a measure of control over that back end that they did not have in other time periods. The Fed can choose whether and when to sell – or not sell – the longer-term bonds.

The outlook for inflation, credit, monetary policy, and the economy are more important for determining the direction of the stock market than the shape of the yield curve, especially after a period of heavy manipulation by the central banks.” (Joe Kalish, Ned Davis Research)

Second, historically we’ve never had an economic recession with earnings growing as sharply as they are today.

Bottom Line

Our economy always presents things about which we can worry. However, the yield curve isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.

Nonetheless, between a Fed likely to raise rates three (maybe four) times this year, now-tightening financial conditions and the flattening of the yield curve, volatility is likely to remain elevated.

 

  1. Historically, when the inverted yield curve was followed by a recession, the average time between the curve reaching its deepest point and that subsequent recession was 20.2 months. In other words, even after an inverted yield curve has hit its lowest point, there was a reasonably long runway before the next recession.
  2. Equity markets are considered to be forward looking, perhaps explaining why investors are getting nervous about the curve’s flattening despite the normal lag to potential following recessions.
  3. The yield curve derives from bond investor expectations. It doesn’t create them. It reflects expectations about the durability of our economic expansion and Federal Reserve actions. If investors believe a recession is imminent, they'll want a safe investment for two years (recessions last 18 months on average). Therefore, they'll avoid Treasury bills of less than two years, expecting to make more money from longer-term ones. As investors flock to long-term Treasury bonds, the prices of those bonds rise – and their yields fall. On the other hand, short-term Treasury bill demand falls, driving their prices lower, raising their yields. When the yield on short-term bills rises higher than the yield on long-term bonds, you have an inverted yield curve.

 

Primary Reference (citation formatted as per their request)

Engstrom, Eric, and Steve Sharpe (2018). "(Don't Fear) The Yield Curve," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, June 28, 2018, https://doi.org/10.17016/2380-7172.2212. Disclaimer: FEDS Notes are articles in which Board economists offer their own views and present analysis on a range of topics in economics and finance. These articles are shorter and less technically oriented than FEDS Working Papers.

Additional References

A key recession signal is back at levels last seen during the financial crisis. Gina Heeb, businessinsider.com. March 29, 2018

Credit Spreads and Business Cycle Fluctuations. Simon Gilchrist and Egon Zakrajsek. American Economic Review: 102, pp. 1692–720. June 2012.

Don’t Fear The Yield Curve: There are always a lot of things to worry about in our economy. The yield curve isn’t one of them. James McCusker, Herald Business Journal. Heraldnet.com. July 7, 2018.

Don’t Fear the Yield Curve Reaper. Liz Ann Sonders, www.schwab.com. April 23, 2018

Economic Forecasts with the Yield Curve. Michael D. Bauer and Thomas M. Mertens. FRBSF Economic Letter 2018-07. San Francisco: Federal Reserve Bank of San Francisco, March 5, 2018.

Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve. Glenn D. Rudebusch and John C. Williams. Journal of Business and Economic Statistics: 27(4), pp. 492–503. 2009.

Predicting Recession Probabilities Using the Slope of the Yield Curve. Peter Johansson and Andrew Meldrum. FEDS Notes. Washington: Board of Governors of the Federal Reserve System, March 1, 2018.

Predicting U.S. Recessions: Financial Variables as Leading Indicators. A. Estrella and F. S. Mishkin. Review of Economics and Statistics: 80(1), pp. 45-61. 1998.

 


Sources:
The Wall Street Journal; The Wall Street Journal Online; Bloomberg News; BBC News; The Associated Press; Reuters.com; Crain’s New York Business; MFS research; NYSE; NASDAQ; Dorsey-Wright Associates; NYMEX.com; CNBC’s Power Lunch & Squawk Box programs; Investing.com; Markit.com; the New York Times; Standardandpoors.com; Djindexes.com; 247wallstreet.com; MarketWatch.com; Morningstar.com; Thomsonreuters.com; the Financial Times.com; Briefing.com; BusinessWeek.com; Dol.gov; Fxstreet.com; Streetinsider.com; Ycharts.com;
 
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