Leaning into the curve
By Joel Dresang
Headlines riled emotions, as they often do, generating more heat than light.
“Leading Recession Indicator Flashes Warning,” alerted one publication. “Recession round the corner?” asked another. “Scary Stuff,” began a third.
At the heart of the matter is a comparison between the yields on long-term vs. short-term government bonds. It has even garnered its own social media hashtag: #InvertedYieldCurve.
“Before you freak out about #invertedyieldcurve make sure you know what it means,” cautioned a tweet from @Investopedia. The reference site suggested putting understanding before fear.
Here is how economists at the Federal Reserve Bank of St. Louis described the yield curve in a blog post in October entitled, “The data behind the fear of yield curve inversions:”
The yield curve is the difference (or spread) between the yield on the 10-year Treasury bond and the yield on a shorter-term Treasury bond—for example, the 3-month or the 1-year.
The yield curve is flattening if short-term rates are increasing relative to long-term rates, which is what’s been happening lately.
The yield curve is inverted if short-term rates exceed long-term rates, making the spread negative.
All else equal, longer-term investments tend to carry greater risks and thus command higher rewards, which is why normally, the yield curve slants higher.
But sometimes, the curve flattens, as it has in recent years, as the Federal Reserve has been restoring short-term interest rates following years of keeping them low to stimulate the economy.
An even rarer occurrence is when the yield curve inverts—when long-term yields get lower than short-term.
On March 22, the yield on the benchmark 10-year Treasury was lower than the yield on the 3-month Treasury. That hadn’t happened since August 2007—a few months before the Great Recession.
The data behind the fear of yield curve inversions, from the Federal Reserve Bank of St. Louis
How interest rates are shaping up, a Money Talk Video with Kyle Tetting
Talking Money: Yield Curve, a Money Talk Video with Kyle Tetting
Strategies for bonds amid rising rates, a Money Talk Video with Marc Amateis
How bonds fared as Fed has raised rates, a Money Talk Video with Kyle Tetting
Bond Yield and Return, from the Financial Industry Regulatory Authority
In fact, the Fed notes, “every recession since 1957 has been preceded by a yield curve inversion.” Which explains the headlines—and the clamor, including a big drop in stock indexes on March 22. But there is more to consider.
Although the last nine recessions followed an inverted yield curve, there have been inverted yield curves when recessions have not soon materialized. For instance, the 1-year yield eclipsed the 10-year in 1965, but the next recession didn’t happen until the end of 1969, more than four years later.
It also matters which shorter-term yields you compare against the 10-year. When the 3-month topped the 10-year on March 22, for instance, yields for the 2-year and 5-year remained lower. By March 29, even the 3-month yield was higher than the 10-year again, and the short-lived inversion was over.
More important than their power to predict imminent recessions is the message that inverted yield curves send to investors.
“A common interpretation is that the yield curve measures investors’ expectations of economic growth in the current period compared with economic growth in the future,” explained the Fed blog post. “According to this interpretation, a yield curve inversion implies that investors expect current economic growth to exceed future economic growth, indicating a recession is likely.”
Recessions are an inevitable part of the endless business cycle, so nobody’s sticking a neck out by predicting there will be one. Inverted yield curves are good predictors, the Fed says, but they don’t forecast when a recession will hit or how severe it will be.
For the last four months of 2000, yields for the 1-year Treasury outdid those for the 10-year, and yet only 16% of economists at the time forecast the recession that started in March 2001. In the middle of that recession, only 7% of economists surveyed believed there was a recession.
“For investors, even if they can predict the direction and timing, they also have to consider the magnitude of any economic downturn,” Kyle Tetting said. “Especially in a shallow or short-lived recession, corporate profitability and stock prices could recover long before the economy more broadly.”
Knowing that another recession might be closer should remind investors to check that their portfolio is balanced, Kyle said, so it can provide the cash flow they need in the short term and the growth they need for the long term. So that they can withstand the next downturn—no matter when it hits, no matter how dramatic.
“The objective isn’t to attempt to predict the future,” Kyle said, “but to determine which way the wind is blowing and adjust accordingly.”
(initially posted April 4, 2019)
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