Many investors are cringing over a trend in long-term bond yield differences, known as the yield curve, that they see as a signal of recession in the coming months. But there's convincing evidence that this is all much ado about nothing.
These investors are anxious over the narrowing difference between yields on the two-year and 10-year Treasury bonds. Yet, few of the fearful are taking a break from hyperventilating long enough to question whether their concerns are valid.
When plotted over time on a graph, the spread of the two rates normally forms a curve — the wider the difference, or spread, the more pronounced the curve. This curve is what's known as the yield curve, though there are other curves involving yield differences.
When long-term bond rates are higher (they usually are because they tend to pay investors more interest for taking more risk), the curve is arch-shaped, sloping up. If differences diminish over time, this arch flattens, and can become a straight line the yield spread diminishes to zero. If the two-year rate becomes higher than 10-year, the curve slopes downward, and is known as being inverted.
Throughout most of market history, the curve has sloped upward because long-term rates have usually been higher. But it has been flattening for more than a decade. At the end of August, the yield curve had shrunk to around 0.2 percent (or 20 basis points), down from about 100 basis points in mid-2017 and from about 250 basis points in early 2014. A flat yield curve is a straight line representing 0 percent difference in the two rates. An inverted curve is expressed in negative numbers.
For investors who rely on this curve as an indicator, flattening raises questions about whether the Fed, in its customary efforts to cool a heated economy with interest-rate increases, might be hitting the brakes too hard in a perennial regulatory balancing act that unavoidably involves over- and under-compensation.
Despite many economic indicators to the contrary, these investors don't view the economy as being all that hot. Fearful that the curve will go flat or invert, they believe that more rate increases will combine with a presumed economic slowdown to pummel stock earnings, ultimately paring back the record highs U.S stocks hit in August. Some investors are already concerned about the market's history of correcting in September.
Yield-curve fears, abetted by a credulous media focused on ratings and clicks, have resulted in the kind of cyclical feeding frenzy that's unique to American markets. People are afraid, so the media focuses on this, stoking fears. At the center of this frenzy is obsession with the curve's flattening, as if it were some kind of Bataan Death March toward recession.
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Yet, despite this yield curve's record of predicting many recessions, investors are looking at the wrong curve. Instead, they should be looking at a historically more reliable curve — one that's signaling no appreciable changes in economic growth around the corner.
Who knew? Everyone should have, because the Fed told us June 28 with a posting on its website under titled "(Don't Fear) the Yield Curve."
The posting discusses a more valid indicator called the near-term forward spread — the difference between near-term forward rates (market expectations of future rates) on Treasury bills six quarters out and the current yield on the three-month Treasury.
The Fed included a chart showing the paths of the curve of the near-term forward spread and that of the long-term yield spread since 1970. While the two lines are often congruent, accurately predicting recessions more or less in unison, the near-term forward spread has been more predictive. For example, it flattened well before the long-term curve ahead of recessions beginning in 2002 and 2007. (So, in those periods, the smart money was following that curve, not the long-term curve.)
Recently, as the long-term spread has been decreasing (and its curve, flattening), the curve of the near-term spread has actually been heading upward, in what is perhaps the more pronounced difference for the period measured. The means recession isn't imminent.
"The current level of the near-term spread does not indicate an elevated likelihood of recession in the year ahead," the Fed states. "Neither its recent trend nor survey-based forecasts of short-term rates point to a major change [in the economy] over the next several quarters."
As it happens, various market and economic factors are much different now than before previous recessions predicted by both curves; the current near-term spread may be reflecting this. Regardless, few people appear to have noticed the Fed's information and analysis, and some who did may have discounted it. While we all complain about taxes, many of us devalue the products of our tax dollars at work, especially when rate "curveonoia" is at pandemic levels.
The near-term spread's reliability stands to reason. Long-term rates are basically set by the market, while short-term rates are directly affected by the Fed's control over the Federal Funds rate.
The long-term yield curve is widely believed to reflect the market's expectations for Fed rate changes — something the Fed should know a thing or two about. Yet, as the Fed has no real control over long-term rates, it makes no intuitive sense to rely on changes in the long-term yield curve as tea leaves these actions or as necessarily being reflective of near-term economic conditions.
"'Curveonoiacs' who just can't give up their obsession could make themselves feel better by girding their portfolios against recession with floating rate funds, bank stocks, dividend stocks and equity REITs."
Indeed, the Fed calls the near-term forward spread an "intuitive" measure. The long-term curve's history of predicting rates is something that somehow has been seized on by a few economists and then amplified by the media, unaware that there's a better, more telling spread whose curve deserves more attention.
All this means that investors should stop worrying about an imminent recession and flinching with each rate increase. According to the Fed, for the next several quarters, we'll probably have a bustling economy that should continue to drive the bull market. After all, that's why it plans more rate increases.
Meanwhile, "curveonoiacs" who just can't give up their obsession, could make themselves feel better by girding their portfolios against recession with floating rate funds, bank stocks, dividend stocks and equity real estate investment trusts invested in warehouses, apartments and low-priced hotels.
For everyone else, it's business as usual — enjoying the strong economy and bull market while they last. Of course, this also means expecting the bull to end, as it always does. But considering evidence contradicting the reigning popular wisdom, it's foolish to get caught up in the frenzy over the wrong curve.
— By David S. Gilreath, partner and founder of Sheaff Brock Investment Advisors
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