The Flattening Yield Curve
Markets are frequently said to face down a wall of worry. One of the more recent worries is an interesting study – that of the flattening, potentially inverting U.S. yield curve. Today’s curve threatens to play the villain, at least according to some current market narratives, to our current economic expansion. Concerningly, a long historical data record supports this view. On the other hand, there is a believable argument for why this time is different. In this month’s Investment Bulletin, we explore the debate and offer how it is impacting our tactical portfolio construction.
First, what is the yield curve? And what does it mean for it to be flat or potentially inverting? The curve measures the borrowing cost (or yield), usually for the government, at each significant maturity term, from the very short (overnight) to the very long (thirty years and beyond). It can take many shapes. A normal curve is upward sloping – meaning rates for longer-term securities are higher than rates for shorter-term securities. A flat curve shows minor or no change in interest rates all along the term spectrum. And an inverted curve slopes downward, whereby longer-term securities yield less than those with shorter terms.
The U.S. yield curve has been steadily flattening for some time, as the Fed has increased shorter-term rates at a pace unmatched by changes in longer-term government bond yields. Specifically, the 2.6% gap between the two-year and ten-year government bond yield as of 2013 has closed to 0.5% as of April 30. As we potentially approach a negative gap (inversion), recession alarm bells pulse. To see why, consider the data.
Historical Data
Figure 1 plots the historical readings for two-year (blue) and ten-year (green) government bond yields back to 1976. Whenever you can see daylight between the two lines, we have a steep curve – there is a meaningfully higher yield offered to those lending for ten years rather than two. Whenever the two lines smudge together, we have a very flat curve; there is little premium offered to those lending for longer. And there are a few instances in history when the two-year yielded more than the ten year, resulting in an inverted curve.
The significance of this is more easily understood through Figure 2. Here we plot the difference between the two yields from Figure 1. Positive numbers indicate the ten year is higher than the two-year yield. Whenever the curve is in this state, we plot with a dark blue line. The lighter blue line shows the times when the curve inverted, with ten-year bonds yielding less than two-year bonds. Last, the gray bars show U.S. recessions.
This picture shows why the shape of the curve, along with other economic indicators we regularly review, impacts how we decide how much risk to take in tactical portfolios (more on this later). The past five U.S. recessions, beginning in 1979, were preceded by an inversion of the curve. There has been up to a two-year lag between the first inverted observation and the official beginning of a recession, but the signal is clear.
Why Does Curve Shape Impact the Economy?
There is some intuition for the shape of the yield curve predicting economic downturns. Shorter bonds should carry less risk than longer bonds of the same issuer; inflation threatens the interest and principal repayment of a two-year bond much less so than a ten year. From a risk-return optimization standpoint, it is odd that investors settle for less yield on a longer bond in the case of an inverted curve. The only logical explanation to lend longer for a lower rate is if you believe that when your shorter-term bond matures, you will have to reinvest at a lower rate than what is on offer today. You may prefer 3% on a ten-year bond over 3.5% on a two-year if you believe that you will only get 0.5% on the next two-year issued in 2020.
Following this logic, the inverted yield curve is the bond market predicting lower short-term rates. Given that low short-term rates are associated with economic trouble, it follows that the bond market predicts a recession when it inverts. The evidence in Figure 2 suggests it has been reasonably accurate.
There is a banking consideration as well. Banks profit when they can lend, at longer maturities, at rates higher than the short-term rate they pay on deposits. An inverted yield curve squeezes this business model. To the extent this dries up credit in the real economy, the inverted yield curve can cause the recession rather than predict it.
Central Banks Busted the Indicator
No matter the strength of the record and the intuition behind it, as the curve flattens a “this-time-is-different” camp has emerged. They argue that central banks have taken unprecedented measures to stabilize the economy since the financial crisis. This economic lifeline included an enormous intervention in debt markets; consider Figure 3 for one illustration of the magnitude. The Federal Reserve owned less than $100 billion of Treasury securities set to mature in each of the 5 – 10 year and 10+ year segments up until the crisis. Since the crisis, the Treasuries held on the Fed’s balance sheet have exploded. In particular, 10+ year Treasury holdings (the red line) ballooned to $600 billion and have since held steady at that level. Short-term Treasury holdings (the blue line) have also increased, but not to the same degree. The implication here is that Fed purchases have artificially depressed longer-term rates.
The relationship between the shape of the yield curve and economic trouble hasn’t been tested in an environment distorted by central banks. Based on this, some conclude that there isn’t anything to read into the shape of the curve or its potential inversion. They would say in a normal world, medium and longer-term rates would be higher, and we wouldn’t be talking about a flat curve now, let alone inversion.
Portfolio Impact
As we reflect on this information, we keep two constants in mind – one can always find a market commentator predicting a looming recession and there is usually some economic data point supporting the prediction. The economic naysayers have increasingly pointed to the curve as the recession warning signal du jour. Given the historical data, investors are forced to evaluate the usefulness of looking at the curve in the current environment.
We believe the relevance of the curve persists. The Fed has certainly distorted the picture, but the long record of evidence supporting the curve-recession relationship is still meaningful. We are, therefore, wary of the this-time-is-different argument. Crucially, though, we don’t assign infallibility to any one indicator. We weigh the curve shape with twenty-six other economic indicators in our tactical toolkit. While the curve sticks out as one of the few arguing for a more defensive portfolio, the preponderance of the data is strong. From earnings to employment to housing, the positives outweigh the negatives. As a result, we position our tactical portfolios slightly on the aggressive side.
We also point out that curve inversion is likely a ways away. It’s true that the curve is now flatter than normal, but we think we are at least a handful of Fed rate hikes away from possible inversion. If the Fed continues on its anticipated path, we might have more to worry about in a year or two. Today we don’t think inversion is imminent, despite the publicity, and we are allocating accordingly – at least until the preponderance of economic data changes our view.□
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