In this piece we discuss:
- The current state of the Treasury yield curve, which has recently inverted (long-term rates falling below short-term rates)
- Why this has historically been viewed as a warning sign for recession, though that has not always been the case
- What inverted yield curves have meant historically and how they should be interpreted
- Reasons why the yield curve might invert other than forecasting a recession
- Why we do not believe the U.S. economy is at risk of an imminent recession
The markets were abuzz in late-March as one of the most widely followed indicators of a potential recession came to fruition in the form of an inverted yield curve between short- and long-term interest rates. This occurred when the 10-year Treasury yield dipped below that of the 3-month rate, albeit by just a few basis points (0.05%), but this nonetheless was enough to sound bearish alarms about the economy and corresponding market volatility.
The slope between the 3-month and the 10-year yields reached a downward trajectory (2.46% vs. 2.41%) on March 26 and officially closed out the quarter basically flat (2.40% vs. 2.41%). The theory behind the predictive power of an inverted curve is that as the economy is believed to slow, longer-term bonds will increase in demand as investors look to lock in future yields on the expectation they will continue to fall as economic growth declines. However, this metric does not have a perfect record, and false alarms have occurred in the past.
Given this backdrop and the fact we have now seen an official inversion between the 3-month and 10-year rates, we believe the following points are important to take into account.
The yield curve between the 2-year and 10-year yields is still positive.
While the 3-month to 10-year spread has inverted, the other closely watched portion of the curve (2-year to 10-year bond yields) is still positive, closing on March 28 at 0.14% (2.27% vs. 2.41%). This is important in our opinion, as there is debate as to which is the more important portion of the curve to follow. While the 3 month to 10 year is considered the most inclusive, the 2 year to 10 year is also believed to be worthy of close observance, since the 2-year bond price is more sensitive to changes in rates than is the 3-month bill.
History has shown that confirmation between these two portions of the curve may be necessary.
While the past three recessions did experience an inversion between the 3-month and 10-year yields in May of 1989, July of 2000, and July of 2006, each of those pre-recession inversions was also accompanied by a downward slope between the 2-year and 10-year yields, which we have yet to see.
In addition, we believe in this instance there could be legitimate reasons for the yield curve to invert other than necessarily forecasting a recession. These would include:
The overseas anchor of long-term rates in other regions of the world.
In Europe and Japan, not only are the 10-year rates considerably lower than those in the U.S. but both are now in negative territory. Strange as that may sound, this continues to reflect the exceptionally accommodative monetary policy of the global banks in those regions. These historically low and negative overseas 10-year yields could well be suppressing long-term rates here in the U.S., based on a relative comparison, and therefore helping to invert the U.S. curve for reasons unrelated to the U.S. economy.
We are coming off a unique period of monetary policy over the past decade and this could also be impacting the slope of the curve.
From 2008–2015, the Federal Reserve held short-term interest rates at zero for seven years and also purchased $4 trillion of bonds in the open market, both of which were unprecedented. Therefore, there is no historical reference point as to how the yield curve may adjust in the immediate aftermath of a rate environment similar to what we have experienced since the financial crises.
The yield curve could also be reacting to the Fed's recent decision to curtail its balance sheet reduction program.
Up until just a few months ago, it was widely expected that the Fed would continue its pace of letting its $4 trillion in bonds (purchased as part of its Quantitative Easing policies of 2008–2014) run off by not investing maturing principal. This, all else being equal, had the impact of reducing liquidity in the long-term markets and increasing the probability of higher yields. As had been anticipated, at its March meeting the Fed announced plans to slow this Treasury bond balance sheet reduction beginning in June and halt it by September. Coincidentally, the 3-month to 10-year inversion occurred the week after this official announcement.
In summary, we do not see the U.S. economy going into a recession this year or next. While we do believe the U.S. economy will slow in comparison to last year, and that the upcoming 1Q19 GDP report could display growth below 2%, we do not see underlying structural dynamics — such as employment trends, wage growth, consumer confidence, and capital spending — reflecting recessionary risk levels. Of course, one must recognize that an upcoming recession is always a risk in any economic cycle and that at some point in the future there will of course be another recession. However, based on the current state of the U.S. economy, we feel the yield curve is likely reflecting other criteria and, while it should be watched closely, is not flashing a recession warning at this time.
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