Curve Ball - Is the Yield Curve Still a Dependable Signal?

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

Over the last 30 years, there has been a widely held belief, supported by data, in the predictive powers of the “slope” of the yield curve.[1] A steep yield curve implies economic expansion in months and quarters ahead. A flat or inverted yield curve implies economic weakness and heightened recession risks ahead. Although the traditional yield-curve analysis does not predict a recession, other equally persuasive indicators do.

The past is not always prologue for the future, so let’s ask the following question: Do those rules apply when the Fed has lowered the Federal Funds rate to unprecedented levels for over seven years and quadrupled the money supply? Questioning the value of traditional analysis is not only appropriate; it is necessary if one is to effectively perform economic analysis given the unique nature of central bank actions.

Traditional yield curve analysis

The graph below shows the slope of the yield curve and recessionary periods to demonstrate the predictive relationship. The first chart plots the yield on two-year Treasury notes and the yield on 10-year Treasury notes. The subsequent chart shows the difference between two-year Treasury Note yields and 10-year Treasury Note yields, otherwise known as the “2-10 curve.” To highlight the predictive nature of the yield curve, periods where the curve was inverted are plotted in red and recessions are highlighted with yellow bars.

2-year and 10-year Treasury Note Yields Data Courtesy: Bloomberg

The 2’s-10’s Treasury Yield Curve and Recessionary Periods Data Courtesy: Bloomberg

A simple deduction from the second chart is that when the yield curve, as measured by the 2-10 curve, has inverted the U.S. economy entered a recession within a relatively short period of time.

Based solely on the last 30 years and the slope of the curve today (1.42%), one would conclude that there is relatively little reason to worry about a pending U.S. recession. In fact, current levels are similar to those when recession typically ended and prolonged periods of economic growth began.

But Fed monetary policy has been far from normal. Investors therefore need to understand that the unprecedented nature of Fed policy and the fact that the Fed Funds rate has been pegged at zero since December 2008 plays a larger part in influencing the shape of the curve than in times past. This unprecedented posture by the Fed is distorting not only the price of money through interest rates but also economic activity. Prices of shorter maturity instruments, such as the two-year Treasury note, are heavily swayed by the monetary policy stance established by the Fed while longer maturity instruments, such as the 10-year Treasury, have been driven by the rate of inflation and economic activity. By keeping short rates artificially low through a zero Fed Funds target-rate policy, the Fed is heavily influencing short-term interest rates and causing the yield curve to be artificially steep. One way to test this theory is to use the Taylor Rule as an alternative Fed Funds target guide.