Yield Curve Inversion
While the 1st Quarter 2019 saw a much-welcomed V-shape recovery from the 4th Quarter 2018 decline, there are still a few clouds hanging around preventing a clear view of the future. Most notably, the yield curve inverted for the first time since July 2007. A yield curve is simply a line chart of interest rates for government bonds, with interest rates on the left axis and maturities on bottom axis. A normal curve slopes upward demonstrating the additional yield investors typically demand in exchange for a longer maturity date. When interest rates for bonds with a longer maturity trade at a lower yield than bonds of a shorter maturity, the relationship is said to be inverted. An inverted yield curve signals that market participants expect rates to be lower in the future than they are today. This can be an ominous sign for the future.
Recently, investors buying the longer term Treasuries produced another inversion of the yield curve measured by the 3-month Treasury and the 10-year Treasury. The chart below shows the shape of the yield curve at two points in March 2019.
The importance of a yield curve inversion as a signal of future information has grown over time. Since the late 1970s, there have been five episodes of a yield curve inversion with each followed by a recession. Due to a longer history of data, the chart on the next page uses the 10-year Treasury and the 2-year Treasury although traders today tend to prefer the 3-month to 10-year measurement. According to the Federal Reserve Bank of New York, there is a 27% probability of a U.S. recession in the next 12 months, based on Treasury spreads. However, history has shown that a yield curve inversion lasting for a quarter precedes an economic recession 100% of the time. Luckily, the ominous yield curve was short lived and lasted only 6 days until March 28. In the past, an inversion had to be sustained for nearly a full Quarter to be considered a reliable signal.
Not your Father’s Yield Curve
The market environment today is not the same environment we had decades ago. Since the Great Financial Crisis in 2008-2009, the Federal Reserve made unprecedented changes to their toolkit, including paying interest on excess reserves parked with the Central Bank. On top of that, the Federal Reserve recently embarked on a relatively more common tightening mission, increasing rates 7 times in the past two years. These actions have the effect of pushing up rates on the shorter side of the curve. Additionally, the Fed’s balance sheet remains swollen from the multiple Quantitative Easing programs that began after the Great Financial Crisis. In this program, the Federal Reserve purchased long-dated Treasuries in exchange for cash, which had the effect of pushing down rates at the longer end of the curve. An astute investor would conclude that these changes, which push up the shorter end and push down the longer end, make an inversion of the curve more likely. These recent unprecedented actions by the Federal Reserve are part of the reason why we urge caution when applying this multi-decade signal.
A Second Opinion from The Conference Board’s US Leading Economic Indicator Index
Looking at current economic data would be another way to gauge the likelihood of recession. Concurrent economic activity has slumped lately, evidenced by a smaller consumer spending number and lower manufacturing activity. However, leading indicators, which forecast the upcoming economic trajectory, suggest a return to growth, albeit a slightly slower growth. The US LEI (Leading Economic Indicator) Index increased in February for the first time in five months,” said Ataman Ozyildirim, Director of Economic Research at The Conference Board. “February’s improvement was driven by accommodative financial conditions and a rebound in stock prices, which more than offset weaknesses in the labor market components. Despite the latest results, the US LEI’s growth rate has slowed over the past six months, suggesting that while the economy will continue to expand in the near-term, its pace of growth could decelerate by year end.”
The current economic expansion has lasted more than nine years, almost the longest bull market in history. However, bull markets do not die of old age; they die of excess valuations, aggressive Fed tightening, or other large shocks. The S&P 500 ended March with a forward P/E ratio of 19.21 according to YCharts (a financial data research platform), which is high but still within the range of normal valuations. Additionally, Fed Chair Jerome Powell recently signaled patience, putting interest rate hikes on hold for “some time.” With the first two conditions all clear, the current stretch of economic expansion could continue for some time.
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