Another Turn in the U.S. Yield Curve Saga

Is the move in two-year U.S. Treasury yields above 10-year yields signaling an imminent recession? Not so fast. 

Financial markets experienced a fresh round of volatility on August 14 after the yield on the two-year U.S. Treasury note moved above that of the 10-year Treasury note for the first time since 2007. This yield curve inversion (which had been preceded by similar moves in the 10-year/3-month Treasury curve earlier this year) appeared to reflect renewed fears of a slowdown in global economic growth, according to a Bloomberg report.

The Treasury curve, to a first approximation, is a reflection of current short-term interest rates—anchored by U.S. Federal Reserve (Fed) policy—and expected future short-term interest rates. Therefore, the curve embeds an expectation of how Fed policy will change in response to evolving economic conditions. When the yield curve becomes inverted (long-term interest rates fall below short-term rates), it shows that investors are expecting the Fed to cut rates in the future. Since investors know the Fed manages monetary policy counter-cyclically in accordance with its dual mandate to achieve maximum employment consistent with price stability, an inverted yield curve shows that investors believe the Fed will cut rates to offset incipient economic weakness.

The slope of the Treasury yield curve between the 10-year and two-year notes is almost entirely determined by the markets’ expectations about future short-term rates; maturities shorter than two years (e.g., the three-month Treasury bill) are more heavily influenced by current Fed policy. Until recently, the yield curve has been inverted from current short-term rates out to a three-year maturity and positively sloped thereafter. Thus, investors have gravitated to a view that the Fed would cut rates in the short term and raise them in relatively short order, consistent with a modest weakening of economic activity. However, the flattening, and subsequent inversion, of the Treasury curve between two years and 10 years signals that investors now believe a more serious downturn is possible, extending the expected period of low interest rates further into the future.

Recessions and the Curve
What’s causing the market’s current agita?  The curve has inverted, to varying degrees, before every U.S. recession since the 1960s, and it looks like the government bond market is well on its way to pricing in a serious downturn. But with stocks only around 6% below recent highs (based on the S&P 500^® Index) and U.S. high yield credit spreads only 106 basis points wider than the tightest in the current expansion (based on the ICE BofAML U.S. High Yield Constrained Index), it appears that risk assets may have not yet fully priced in a significant decrease in U.S. economic activity, which may suggest the possibility of further volatility in the short term.

Chart 1. The 10-Year/2-Year Curve Has Inverted for the First Time Since 2007
10-year/2-year U.S. Treasury curve, January 1, 1961–August 14, 2019

Source: Bloomberg. Data as of August 14, 2019.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

Investors have turned more pessimistic as worries about a global trade war and associated negative effects on business capital spending are reinforced by a bubbling cauldron of other risks: apparent economic weakness in China and Europe, increasing risks of a hard Brexit, and rising emerging market risk stemming from the consequences of political uncertainty in Argentina. In addition, the record length of the current U.S. economic expansion naturally lends itself to worries that a downturn is approaching. With already-wide government deficits and record low interest rates in most of the developed world, it would appear that there is little leeway for macroeconomic policy to counter the conditions that could lead to a global downturn, even a milder one than the “Great Recession” of 2008–2009.

History shows that while the yield curve has always inverted before a recession starts, the lag between the initial inversion and subsequent recession can be three years or longer. The curve can also invert and de-invert without a recession starting. Sometimes, investors can be wrong about the future of the economy and subsequent changes in short-term interest rates; there is no gravitational vortex that forces the economy into a recession once the yield curve has inverted.

A Reality Check on U.S. Financial Conditions
Moreover, while the shape of the curve has been reliably correlated with future economic outcomes, it is not the cause of them. (As we have noted before, the yield curve is not necessarily a precise indicator of the timing of a recession.)  We think a broader causal mechanism, from tightening financial conditions to future economic activity, is captured by the Chicago Fed National Financial Conditions Index (NFCI). This broad measure includes the slope of the yield curve along with a host of other direct indicators of credit spreads, funding conditions, liquidity, and expected volatility. The NFCI also has a reliable history of tightening before the start of a recession.

What is it telling us now? In our view, the NFCI currently shows that financial conditions are too accommodative to forecast an imminent U.S. economic downturn.

Chart 2. Inverted Curve or No, U.S. Financial Conditions Remain Accommodative
Chicago Fed National Financial Conditions Index, January 1, 1971–August 14, 2019

Source: U.S. Federal Reserve Bank of Chicago. Data as of August 14, 2019. U.S. financial conditions are represented by the Chicago Fed National Financial Conditions Index (NFCI), an indicator of financial stress and tightness of credit markets. The higher the index value, the tighter financial conditions are for the U.S. economy.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

Implications for Investors
In a commentary on an earlier inversion, we said that “if the yield curve returns to a positive slope, it’s likely that this will go hand in hand with investors becoming at least somewhat more positive about future economic growth and pushing back their forecasts of the starting date of the next downturn.” We still believe that outcome would provide stocks and credit the opportunity to potentially outperform Treasury bonds in the months ahead.