It has been almost four weeks since the inversion of the 3-month/10-year US Treasury yield curve, and the commotion is just now finally beginning to fade.
In some respects, the attention this event generated is understandable—inversions have preceded every US recession for the past 60 years. When the normal relationship between yields and maturities inverts, and short-term bonds yield more than longer-dated bonds, it can be a powerful warning that there’s danger ahead for the economy.
However, we do not believe this is the case for the inversion that occurred on March 19. With the US economy continuing to show moderate growth, and inflation pressures contained, we question whether this mild and short-lived inversion provides a reliable signal that a recession is on the way.
This Yield Curve is Essentially Flat
As a predictor of future economic recessions, the signal an inverted yield curve is sending grows stronger and more reliable along with increases in its magnitude, steepness and duration. The inversion itself is far less meaningful.
By this measure, the inversion that began on March 19 and ended five days later was hardly much of an inversion at all. At its steepest point, 3-month Treasury yields exceeded 10-year yields by just 6.5 basis points. The table below shows how these numbers compare to the inversions that signaled the 2007 and 2001 recessions.
|
Inversion
|
Maximum Gap
|
Duration
|
|
March 2019
|
6.5 basis points
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6 days
|
|
Pre-2007 Recession
|
62 basis points
|
1+ year
|
|
Pre-2001 Recession
|
80 basis points
|
6 months
|
Our View on Forces Shaping the Curve
In simple terms, the shape of the yield curve reflects the market’s outlook and expectations for both monetary policy and future economic growth. But there are also a number of other factors in play today, including:
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Supply: New issuance of Treasury bonds ramped up significantly in 2018 as the Treasury Department looks for ways to address the US government’s growing budget deficits. Compared to the previous year, volume was up 24% for Treasury bonds (which mature in 10 years or more), 120% for Treasury notes (which mature in one to 10 years), and most notably, 180% for T-bills (which mature in less than a year). This emphasis on the front end of the curve increased supply at a time when demand was limited, putting downward pressure on short-term bond prices and additional upward pressure on short-term rates.
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Normalization: The Fed raised short-term interest rates four times in 2018, while longer-term bond yields were constrained by modest economic growth and low inflation. The result was a flattening of the yield curve.
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Late Cycle Growth: While economic conditions in the US are near perfect for equity investors—with modest GDP economic growth, low interest rates and muted inflation—the economy is in the late stages of one of the longest expansions in history. Investors understand that the scope of potential catalysts for a surge in economic activity is limited.
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Inflation Expectations: When investors expect inflation to rise, they demand higher yields, or premiums, from longer-term bonds. But with inflation expected to remain stable for the next ten years, no premium is required for long-term Treasuries.
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Global Weakness: The yield curve is also influenced by central bank activity and economic conditions abroad. In much of Europe and Asia, GDP growth trails the US, and monetary policy remains accommodative. This is keeping interest rates outside the US inordinately low, acting as an anchor on US yields.
Taken together, these influential factors lead us to agree with former Fed chairman Alan Greenspan, who recently told Congress that the US yield curve’s “efficacy as a forecasting tool has diminished very dramatically” because of such unusual economic conditions and events.
Inversions are Terrible at Timing
One more thing to keep in mind about inversions is that, although they have ushered in every US recession for the past 60 years, they have done a poor job of timing the start of these downturns. Since the 1960s, the average “inversion to recession” lag time has been around 14 months, ranging from a maximum of 19 months to the shortest gap of seven months.
What’s Ahead? Three Warning Signs to Look For
With these considerations in mind, we believe the Fed’s recent pause in rate hikes will support continued growth in the US economy and expect the yield curve to return to a more traditional, positive slope in the future.
However, we also continue to monitor the economy for red flags.
More specifically, we are looking for any indications of these three developments taking shape:
- A meaningful deterioration in the outlook for global growth.
- Global central banks taking a more hawkish stance on monetary policy.
- Yield curve inversions that are a steeper and more persistent than the March inversion.
If these three conditions appear for an extended length of time, we will be convinced that the yield curve has something important to say.
Jeffrey S. MacDonald, CFA is Head of Fixed-Income Strategies, Fiduciary Trust Company International.
© Fiduciary Trust Company International.
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