Why you should – or shouldn’t – care about the yield curve | Economy
Investors and observers of the US economy have plenty to worry about these days: inflation hitting a 40-year high, a ground war on the European continent, an aggressive Federal Reserve raising rates of interest and a political deadlock in Washington.
And then there is the yield curve.
The curve is actually a line that measures the yield of different bond durations. In normal times, the line should curve upwards as yields rise the longer the duration of the bond, reflecting the greater risk of the unknown. Shorter duration bonds, such as 2-year Treasury bills, are expected to yield less than 30-year bonds.
But last week, the 2-year had a higher yield than the 10-year. This means that the yield curve has been inverted.
Inverted yield curves reflect uncertainty about the future course of the economy and often serve as a warning sign of a coming recession, but not always. And this is not a timing signal per se, as the curve may remain inverted for some time before a recession occurs. Sometimes this can turn out to be wrong. And, in the case of the 2/10 line last week, it came back within a day before reversing again.
Yet it’s undeniable that bond investors are spooked, primarily by consumer inflation stubbornness that Federal Reserve Chairman Jerome Powell and President Joe Biden’s economic advisers described a year ago as “transitional.” .
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The immediate cause of the reversal was a March 21 speech where Powell sounded more hawkish than he had before. The speech follows the Fed’s first rate hike in four years, when it raised rates by 25 basis points in mid-March.
“We will take the necessary steps to ensure a return to price stability,” Powell told the audience of business economists. “In particular, if we conclude that it is appropriate to act more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”
This signaled to bond traders that the Fed would raise rates by 50 basis points in May and would struggle to engineer a “soft landing” for the economy that avoids a full-scale recession.
“I think the biggest worry is that the Fed is killing this economy,” says Megan Greene, chief economist for the Kroll Institute and senior fellow at Harvard University’s Kennedy School.
Which Yield Curve Matters?
Last week, the market focused on the spread between the 2-year yield and the 10-year yield. This makes sense, as traders have a short-term horizon. On Monday morning, the 2-year yield was 2.44%, while the 10-year yield was 2.391% – a slight reversal.
But others, and in particular the Fed, tend to pay attention to other returns, those of 3-month and 10-year Treasuries for example. Right now the 3-month yield is at 0.533, well below the 10-year’s 2.391 – no reversal here.
Some, including Powell, cite a more granular reading, focusing on the shorter end of the curve, as he said in response to a question after his March 21 speech.
“Frankly, there’s some good research by the staff of the Federal Reserve system that really says to look at the short — the first 18 months — of the yield curve,” Powell said, according to Bloomberg. “It’s really what has 100% of the explanatory power of the yield curve. It makes sense. Because if it’s reversed, that means the Fed is going to cut, which means the economy is weak.
So far, this one currently shows no reversal.
Strategists at BCA Research analyzed the various yield curves last week and while they concluded that the inversion is a reliable indicator of recession, it did include some caveats. BCA called the measure cited by Powell the slope of the Fed.
“The 2-year/10-year Treasury slope reversed before 7 of the last 8 recessions and did not send a false signal,” the report said. “The 3-month/10-year Treasury Slope did even better, calling 8 of the last recessions with no false signal. The Fed Slope, meanwhile, also called 8 of the last 8 recessions, but it sent a false signal in September 1998.”
No matter what people choose to focus on, an important consideration is that yield curve inversions can mean that a recession will occur. But when they happen can vary widely, and the economy and markets can often continue to be positive for some time.
“Over the past six economic cycles in the United States, the 2-10-year gap first reversed 18.6 months before the start of the next recession on average,” said Jason Pride, director of Private Wealth Investments and Michael Reynolds, vice president of investment strategy at Glenmede Trust, wrote Monday. “The spread between 3-month and 10-year treasuries has a slightly better track record, leading recessions by 17.3 months on average.”
The pair said their company’s model currently suggests the likelihood of a recession in the next 12 months is low, at less than 10% chance.
“However, the main risk to the outlook would be an aggressively hawkish monetary policy, so the Fed should proceed cautiously on its tightening path,” they added.
Has the pandemic skewed things?
The coronavirus has caused a dramatic shock to the economy, resulting in the most severe but also the shortest recession on record. Some cite the inversion of the yield curve in 2019 as proof of its accuracy as a recession followed in 2020, but this was prompted by the unusual nature of the pandemic as countries around the world participated in a synchronized stop. It is possible that there would have been no recession if the pandemic had never happened.
Then there’s the unprecedented nature of the pandemic response, with the Fed buying trillions of bonds and other securities to keep interest rates at historic lows and keep financial markets stable. Did the Fed’s actions create a distortion in the bond market?
John Mousseau, president, CEO and head of fixed income at Cumberland Advisors, notes that before the arrival of the coronavirus in the United States, the yield on the 10-year Treasury was 1.9%. Then it hit a low of 0.5% in August 2020 as the economy struggled.
“So compared to (1.9%) a 60 basis point rate hike seems more reasonable, especially as inflation has risen (although we also believe we will see a pullback in the inflation later in the year)”, Mousseau added.
He also points out that market rates were already on the rise before the Fed intervened in March, undermining the idea that the recent unease in the bond market is a reaction to central bank actions.
“We don’t think the market is driving the Federal Reserve as much as a post-COVID mean reversion,” Mousseau added.
The curve may serve economists more than investors
One of the key factors of any yield curve inversion is that while it can often predict darker days for the economy, it is not a sell signal for those investing in equities.
“What should matter most to investors is the signal the curve can give to markets,” Glenmede’s Pride and Reynolds said. “Over these past six (economic) cycles, the S&P 500 has actually shown positive returns between the reversal and the actual onset of the recession in the United States”
For now, inflation and its direction are probably more worrisome than the fact that the yield curve may be inverted.