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Economic Insights

With long-term Treasury yields once again dipping below short-term yields, we examine the implications for the U.S. economy, U.S. Federal Reserve policy, and key asset classes.

Like the rest of the investment world, we have been watching the U.S. Treasury yield curve very carefully, especially after the March 22, 2019, inversion of three-month/10-year Treasury rates. Inversion has once again become a focus in recent weeks: As of June 4, the broad yield curve, which measures rates across the Treasury maturity spectrum, had a downward slope from very short maturities to the three year point, sloping upwards thereafter.

 

Chart 1. State of Inversion: The U.S. Treasury Yield Curve
Yield on U.S. Treasuries for indicated maturities, as of June 4, 2019

Source: Bloomberg. Chart represents yield of U.S. Treasury securities across available maturities as of June 4, 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.

 

In our view, the current curve reflects market expectations that the U.S. Federal Reserve’s (Fed) policy arm, the Federal Open Market Committee (FOMC), will reduce rates by 75-100 basis points from the current 2.375% mid-point of the Fed funds target range over the next 12 months.

Since the FOMC has shown a distinct preference for multiple small rate cuts as opposed to fewer, larger moves, it is not unreasonable to believe that if it does start easing, it will end up doing so multiple times before rates stabilize at a lower level. Of course, a “one and done” approach is not unheard of, but is usually applied to quell financial risk. Case in point: The Fed’s move to calm markets amid the Russian debt default in 1998.

Gauging Recession Risk
A closer look at recessionary periods after the 1960s reveals that the yield curve inverted before each downturn. However, if we exclude isolated months that are far removed from economic peaks, the lead time between the initial inversion and the subsequent business cycle peak varied widely.

For example, since financial deregulation in the late 1970s, the three-year/one-month version of the Treasury curve has inverted between five and 19 months before a U.S. recession started. Moreover, it flashed at least nine false signals during that period—inversions that were followed by de-inversions as investors’ expectations about Fed policy proved ill-founded.

 

Chart 2.  An Inverted Yield Curve Signals Recession—Except When It Doesn’t
Yield curve differential of the three-year U.S. Treasury note and the one-month U.S. Treasury bill (monthly except for endpoint), June 30, 1961–June 4, 2019

Source: Bloomberg. Shaded areas indicate recessionary periods. False signals are points at which the yield curve inverted and then subsequently turned positive without occurrence of recession.
Performance quoted above is historical. Yield curve represents differential between three-year and one-month U.S. Treasury yields. 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.

 

Thus, the market doesn’t have systematically superior knowledge to the Fed, although it does understand that the Fed tends to cut rates in a series of small moves that cumulatively add up to something larger.

Fed Signals
The current environment is one in which forecasting rate cuts is particularly difficult and very likely makes the Fed yield curve inversion signal even less reliable than it has been in the past. Two reasons why:

  • The Fed only started targeting 2% inflation in 2012, and nobody knows the relative weighting it attaches to meeting its inflation objective versus meeting its goal of fostering maximum employment; under current circumstances, the “dual mandate” is more opaque than usual.
  • Low inflation and low inflation volatility have narrowed the term premium—the risk premium for maturity extension and other factors—or even turned it negative. This makes it much easier for the yield curve to invert without necessarily signaling rate-cut expectations consistent with recession.

Both factors make it likely that the current yield curve inversion is an even noisier signal than it has been in the past, lengthening the lead time between inversion and a potential recession.

The best response to this is to call on other indicators that have been more reliable guides to cyclical peaks; leading economic indicators (as represented by the Composite Index of Leading Indicators) and broad financial conditions (as measured by the Chicago Fed National Financial Conditions Index). (See our in-depth analysis in the April 12, 2019, Fixed-Income Insights.) Both currently negate the recession warning given by the inverted yield curve and suggest the end of the current economic expansion is not on the horizon yet.

Implications for Investors
Given the volume of media coverage of the recent curve inversion, investors may have a number of questions. What should they be thinking about in a low-rate environment in which the risk of near-term recession still appears small? 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. If so, stocks and credit should outperform Treasury bonds handily, in our view.
 

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