In recent months, pundits have cautioned about a flattening yield curve,
suggesting it may signal the end of the economic expansion, the end of the bull
market, possibly even the end of the world as we know it. There's plenty to
worry about in the markets, but in the spirit that knowledge is the enemy of
ignorance, let's clear up some myths.
First, what is yield curve steepness? It reflects the relationship between
the short end and long end of the yield curve. Got it? Okay, let’s dissect
this jargon:
·
The “short end” of the yield curve refers to shorter-term
interest rates. This could be the current Federal Funds Target that the
Federal Reserve Open Market Committee (FOMC) controls and is colloquially
referred to as the current interest rate; more broadly, it is referring to
yields on Treasury securities of a few years. In the context of our
discussion, many refer to 2 years or 3 years (although some go out as far as
5 years).
·
The “long end” of the yield curve refers to longer-term
interest rates. This is often the yield on the 10-year Treasury bond,
sometimes the 30-year Treasury bond (also called the “long bond”).
·
For some context, before the financial crisis, it was generally
believed the Fed controls the short-end of the yield curve, whereas the
long-end of the yield curve is more of a reflection of the longer run
potential of the economy and longer run inflation expectations. Since
the financial crisis, there’s a plethora of opinions to what extent the Fed’s
quantitative easing (QE) has influenced longer-term rates.
·
The steepness of the yield curve is the difference between the
yield at the long end of the yield curve and the short end of the yield
curve. The 2s10s yield curve, for example, is the yield of the 10-year bond
minus 2-year Treasuries plotted across time.
·
The yield curve is steep when short-term rates are lower than
long-term rates; it is “flat” when they are the same; and the yield curve is
inverted when short-term rates are higher than long-term rates.
·
In a classic banking model, banks borrow money short-term to
make long-term loans. As such, when the yield curve is steep, the more money
banks lend, the more money they make (assuming their borrowers don’t
default); as the yield curve flattens and potentially inverts, margins could
get squeezed and potentially become negative. It’s a tad more complicated
than that because private borrowers pay a higher rate than that available to
the government. An inverted yield curve may suggest that the Federal Reserve
wants to slow the economy down.
With this context, please look at the chart above which also shows the
unemployment rate and recessions. The yield curve has been flattening since
2010; if you listen to financial media, you might think it's a new
development. The fact that the yield curve is flattening or at a relatively
flat level does not really mean anything by itself, for example the yield curve
was relatively flat in the second half of the 1990s and economic growth
remained strong for years. The advertising-based media model means that media
outlets want your attention all the time, and therefore they tend to generate
fear inducing headlines like "US
Treasury yield curve hasn't been this flat since 2007" just to get
you to click.
Ahead of the financial crisis in 2007, the yield curve was actually
steepening, not flattening. In our assessment, the proper comparison between
now and the prior cycle is actually 2005, not 2007. The point is that you
often see the yield curve actually steepening within the year prior to a
recession, having been inverted prior to the steepening. Please see the black
line on the above chart.
Tying it back to markets, the S&P 500 topped in October 2007, well
after inversion and while yield curve steepening was already underway.
Taking a longer-term perspective: for the nine recessions since 1954, all
were preceded by a 3s10s inversion, the average length of time before the subsequent
recession was 15 months, with 10 months being the shortest amount of time,
and 20 months the longest. There were four false signals: in 1965, in 1967,
in 1971 and in 1998. So historically a 3s10s inversion was a necessary but
not sufficient signal for a recession, and there was at least a 10-month lag
before the subsequent recession started.
Even given the historical evidence, it is certainly possible that the next
recession will start without the yield curve inverting ahead of time.
However, if history is any guide, the balance of probabilities seems it
suggest that inversion will happen again prior to the next
recession. But that doesn’t mean a flattening yield curve is an imminent
warning sign. Instead, in today’s context, we believe a better characterization
may be that the flattening yield curve is a reflection that the Fed believes
the brakes ought to be applied (even if they want to do so ‘gradually’) to a
strong economy.
Will it end in a recession? Of course. The probability of a recession is
100%, as J.P. Morgan CEO Jamie Dimon quips; the question is not whether a
recession will happen, but when.
In taking the yield curve steepness as a model, we should take note of any
inversion. That said, we would likely be far more concerned about a downturn
in the economy should the yield curve steepen once again after the inversion
has occurred.
For context, the US 10 year yield is, as of this writing, just under 3%;
it hit a low of 1.36% in 2016. The Fed funds rate right now is set to be
between 1.50% and 1.75%, so if the economic outlook deteriorated, the U.S.
10-year yield should fall below this level to invert the yield curve.
More likely, in our assessment, is that the Fed continues to raise
rates, pushing shorter-term rates higher, thus gradually flattening the yield
curve further.
The exceptions to witnessing a yield curve steepening prior to recession
were in the late 1970s and early 1980s, a time when monetary policy was very
volatile in large part due to the fact that inflation rates were running
high. We will be publishing a research report on inflation in the coming
days, as well as hold a webinar (register
here) on inflation topic on May 24. Notably, we will look at how
demographics may have been a substantial contributing factor to inflationary
pressures in the 1970s.
It is in the above context that we view a flattening yield curve (that is
not inverted) as a positive indicator for the business cycle over roughly a
six-month outlook. The steepness of the yield curve is but one indicator of
where we are in the business cycle (please see our chart book
on the business cycle). Part of the confusion with financial market discussions
generally may come from a lack of distinguishing time frames. Hence, for the
time being, the flattening yield curve is, in our assessment, a positive for
the economy over the near term.
To expand on the discussion, please register to join our
Webinar on Thursday, May 24 at 4:15pm ET. Please also register for our newsletter to be informed
when our next chart book gets published.
Axel Merk & Nick Reece
Merk Investments
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