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Market View

Investors may be concerned about the potential implications of a dip in long-term yields below short-term yields. Here, we provide some important context.

 

In Brief

  • The recent inversion in the U.S. yield curve has caused concern in financial markets because such inversions are popularly seen as a harbinger of U.S. recession.
  • But the yield curve is an imperfect indicator, as it has a history of false signals. Meanwhile, other economic indicators covering a wide range of data sources do not point to recession at this time.
  • Moreover, unprecedented central bank activity and low levels of yields have further complicated the yield curve signal by distorting traditional curve dynamics. 
  • While it is unusual to have a recession that has not been preceded by an inversion, it is also unusual to have a slump without a downturn in other key indicators that, so far, have not offered such signals. 

 

Will the inverted U.S. yield curve turn the economy upside down? The year-long trend in declining yields that brought the U.S. Treasury curve to levels of flatness not seen since before the 2008–09 financial crisis reached a new milestone on March 22, 2019, when the yield on the 10-year U.S. Treasury note dipped below the yield on three-month U.S. Treasury securities.  (The U.S. Federal Reserve's (Fed) decision to hold off on rate hikes in 2019, after citing slower economic activity in the first quarter of 2019, was the likely catalyst.)

While the yield differential between 10-year and two-year U.S. Treasury securities has been the subject of considerable analysis (and hand-wringing) among financial commentators as a potential indicator of a looming U.S. recession, the spread between 10-year and three-month Treasury rates has actually been a far better predictor of downturns. The fact that the 10-year/three-month spread had actually inverted, albeit slightly, indicated for some analysts that the market is beginning to price in an imminent U.S. recession. 

 

Chart 1. Does an Inverted Yield Curve Signal Recession?
Yield curve differential of the 10-year U.S. Treasury note and the three-month U.S. Treasury note, June 30, 1983–March 22, 2019

Source: U.S. Federal Reserve Bank of St. Louis. Shaded areas indicate recessionary periods.
Performance quoted above is historical. Yield curve represents differential between three-month and 10-year 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.

 

However, other important indicators of potential recession appear to be signaling very different economic outcomes. Various measures of U.S. financial conditions—particularly the index published by the Chicago Federal Reserve Bank—indicate that conditions are historically easy, with no signs of stress in the system. Also, the Conference Board’s index of leading economic indicators, a widely watched basket of economic and market bellwethers, did not signal any type of economic slowdown in its February 2019 update.

Why are we getting such a sharp contrast in apparent signals from these economic and market indicators?  There are several key factors to consider. First, we need to clarify the relationship between the yield curve and likely recession: an inversion merely serves as a potential signal of a slowdown; it does not by itself cause businesses and consumers to pull in their horns. Next, we should distinguish between the success of an indicator and the potential for false signals. And finally, we need to consider how the unique circumstances of today’s market environment may impact market-based signals.

1. Can an inverted yield curve cause recession on its own?
One pervasive misconception among many investors is that an inverted yield curve leads to a recession; that is, that some dynamic in the marketplace triggers a recession from an inversion of interest rates (shorter maturity yields higher than longer maturity yields). Indeed, this may well have been the case prior to some financial deregulation in the late 1970s; restrictions on bank activity sharply reduced deposits—and thus, bank lending and available credit in the United States—when overnight rates rose above longer-term yields.

However, the only behavioral considerations currently in place that we need to consider with an inverted yield curve are shifting incentives for borrowers and lenders. Lenders and investors who can no longer capture incremental returns from extending the maturity of their debt must assume increasing amounts of credit risk to maintain target returns. Equity risk premia and credit spreads tend to outperform in the 12 months following inversion. While this dynamic can lead to overly easy credit availability for borrowers, and for investors to assume investment risks that may be misaligned with their risk tolerance (sowing the seeds for future market problems), a flat or inverted yield curve more directly leads to further credit expansion—not recession.

2.  Is there a foolproof recession predictor?
So, why all the anxiety about yield curve inversions? Because, in the endless quest of many analysts to predict economic contractions, yield curve inversions have some of the highest signaling success of available metrics, and are perhaps most easily accessible for many investors.

But the idea that a particular market signal is successful in predicting recessions runs counter to another fact: it is exceptionally difficult to predict a recession. The problem here is not only that curve inversions aren’t perfect predictors; curve inversions tend to give us a number of false signals. That is, while many recessions are preceded by curve inversions, it is also fairly common for the yield curve to invert without a recession arriving in tow. So while it is rare to have a recession without the curve inverting first, it is common to have the curve invert without a recession. Investors must be clear that a simple inversion alone does not tell us that a recession is coming. Therefore, we think it behooves investors to keep an eye on other indicators.

Which ones? In particular, we find that a comparably effective predictor—with fewer false signals—is that of various baskets of leading indicators. To be sure, some baskets of leading indicators also have their problems, one of which is that they are often statistically retrofitted to align better with prior recessions.  (That is, the data may be overstating their predictive ability because they were specifically built to work with prior experience). However, we have also found more granular assessments of leading indicators (aggregations of state-by-state data) provide similar levels of efficacy, without some of the issues surrounding statistical manipulation.

One point of focus for us is the Philadelphia Fed State Diffusion Index,* which provides a wide range of data that has proved to be as effective as curve slope in predicting recessions, but with fewer false positives.  Said differently, drops in the Diffusion Index occur before recessions as often as yield curve inversions, but with fewer false signals. While still an imperfect indicator, drops in the Diffusion Index are more likely to signal a recession than a yield curve inversion.

What does this all mean? Recessions are, as stated above, notoriously difficult to predict. While investors may like simple answers, markets are complex and constantly evolving, and tend to defy oversimplification.  There is, indeed, a potentially predictive relationship between yield curve shape and economic downturns, but one that historically has included a number of false positives. As famed investor Paul Samuelson once declared about another questionable predictor, equity prices, “the market has predicted nine of the last five recessions.” Therefore, it is incumbent on investors to both stay humble, and also to avoid the trap of relying on any single metric, which may work sometimes and fail to work other times.

Consideration of multiple indicators can give us a more rounded perspective.  As of this writing, both the CFNAI (Chicago Fed National Activity Index)** and the Philadelphia Fed Diffusion Index are indicating a positive outlook for economic activity, while only the yield curve is giving us the possible negative market signal.  What are we to make of these diverging signals?

3.  Are conditions different this time?
One problem with historical comparisons is that underlying variables that we assume to be constant may shift over time.  In this case, there are several possible factors that impact the shape of the yield curve that are quite recent, and may cause the curve to behave differently than through prior decades of history.  Yields are historically low; global central banks have significantly expanded their balance sheets by purchasing sovereign debt; and both inflation and the volatility of inflation have been trending down for decades.  All of these call into question the viability of the signaling efficacy of the Treasury curve.  Unprecedented central bank activity since the global financial crisis has resulted in low and stable yields around the world, dampening volatility and chasing investors into new areas to seek returns.

Among the most obvious and tangible impacts of the quantitative easing asset purchase program first initiated by the Fed, soon followed by its counterparts in the eurozone and Japan, was both a lowering of yields and a flattening of the yield curve.  The average duration of assets now owned by the Fed significantly exceeds that of the outstanding debt of the U.S. Treasury; that is, the Fed’s purchase of Treasuries has created explicit flattening pressure on the U.S. yield curve, while also driving rates lower.

One way that we can see this is via the concept of “term premium”, or the incremental compensation for taking term risk received by investors.  As we can see in Chart 2, that compensation has been non-existent to negative for years. The normal relationship between maturity and investor compensation has been taken out of the marketplace, and only other unprecedented actions from the Fed—specifically, maintaining a near-zero fed funds rate—prevented this from impacting the shape of the yield curve earlier via lower yields on longer maturities than the market might otherwise demand.  

 

Chart 2. Term Premium Recently Reached Historical Lows
Term premium on the 10-year U.S. Treasury note, June 30, 1961–March 22, 2019

Source:  Federal Reserve Bank of New York. 
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

 

Low future expectations for inflation, in addition to a tight range for inflation in the United States for the past 25 years, may also be contributing to a flatter than usual curve; the market appears to require very little compensation for uncertainty around inflation. Finally, the low absolute level of interest rates, combined with low interest rates in other developed economies, may well be impacting traditional yield curve dynamics. Typically, investors will add longer maturity Treasuries when they anticipate that the Fed will need to cut many times, thus driving rates lower. However, with rates already quite low from an historical context, the potential upside for investors to benefit from a fall in interest rates is more limited, and investor behavior has clearly departed from prior norms.

In short, we hear constantly about how different this recovery has been from prior recoveries, and we know that the Fed’s unprecedented actions have left a substantial footprint in the marketplace. Why, then, should we expect other historical relationships to be untouched?

Summing Up: The Yield Curve Is Not a Definitive Bellwether of Recession
Investors are rightly cautious about risk assets and the potential for an economic downturn given the extended period of economic expansion we have experienced over the past decade, combined with slow economic growth in other developed economies, and today’s relatively low compensation for taking investment risk. So they may be understandably concerned by the fact that one commonly watched recession indicator has recently started flashing alarm signs.

However, there are many reasons to be skeptical of the yield curve as a reliable predictor of economic downturns. It has a history of many false signals, while other indicators appear to be sounding the “all clear.” Moreover, unprecedented central bank activity and low levels of yields have distorted traditional yield curve dynamics. While it is unusual to have a recession that has not been preceded by a curve inversion, it is similarly unusual to have a recession without a sharp downturn in a variety of economic indicators that, so far, have not shown anything of the sort. While it is impossible to predict the economic future with any degree of certainty, we can at least arm ourselves with analysis that extends beyond a distorted and misunderstood market indicator.

 

*The Federal Reserve Bank of Philadelphia produces a monthly coincident index for each of the 50 U.S. states. The coincident indexes combine four state-level indicators to summarize current economic conditions in a single statistic. The four state-level variables in each coincident index are nonfarm payroll employment, average hours worked in manufacturing by production workers, the unemployment rate, and wage and salary disbursements deflated by the consumer price index (U.S. city average). The trend for each state’s index is set to the trend of its gross domestic product (GDP), so long-term growth in the state’s index matches long-term growth in its GDP.

**Produced by the Federal Reserve Bank of Chicago, the Chicago Fed National Activity Index (CFNAI) is designed to gauge overall economic activity and related inflationary pressure. The CFNAI is based on a weighted average of 85 existing monthly indicators of national economic activity. It has an average value of zero and a standard deviation of one.

 

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