Ever since Dec. 3, 2018, when the yield curve inverted (with the yield of 2.83% on the five-year Treasury note 1 basis point lower than the yield of 2.84% on the three-year Treasury note), I have been receiving calls and emails from worried investors about the impact of an inverted yield curve.
The reason they worry is the much-publicized relationship between inversions and recessions—inverted curves have predicted all nine U.S. recessions since 1955. You can observe the relationship in the following chart from WealthManagement.com, which shows the yield spread between two-year Treasury notes and 10-year Treasury notes during the most recent recessions (shaded in gray).
Recent history shows that a recession follows yield curve inversion in an average of 16 months, and the setback lasts, peak to trough, for an average of 12 months. The question is, should you be worried about the inversion?
Before tackling that issue, it’s worth noting that, on Dec. 3, 2018, the S&P 500 Index closed at 2,790. On April 3, 2019 it closed at 2,873, a gain, not including dividends, of about 3%. It’s also worth noting that, given concerns about a slowdown in global economic growth, on March 20, 2019, the Fed announced it does not expect to raise rates further this year. That said, should you be concerned, or acting, based on the recent inversion?
Should You Care?
To begin, it is important to understand that what matters is not just the relative level of interest rates, but whether the Fed’s policy is accommodative or contractionary. The reason we have experienced recessions after inversions is that Fed policy was contractionary as it tried to fight inflationary pressures. By raising real interest rates to levels sufficient to slow demand and fight inflation, the Fed can cause a recession.
With this understanding, we should ask whether Fed policy is currently in a contractionary or accommodative regime. When it comes to monetary policy, it is the level of real interest rates, or the inflation-adjusted federal funds rate, that matters.
On average, the real federal funds rate is positive. Over the last seven decades, it averaged about 1.3%. We fell well below that level in January 2008, when the Fed slashed rates to try to prevent a depression. The Fed has kept policy accommodative since then. The latest forecast from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters is for inflation to be 2.0% in 2019. With the current three-month Treasury bill rate at 2.42%, we have a real three-month Treasury bill rate of just 0.42%, well below the historical average of 1.3%.
Clearly, monetary policy is still accommodative and supportive of economic growth. As long as the real federal funds rate remains at relatively low levels and the nominal federal funds rate is basically flat relative to the five-year and 10-year Treasury notes, investors should temper any concern they have about an inversion in the yield curve.
In addition to relatively loose monetary policy, we also have massively stimulative fiscal policy, with the budget deficit at about $1 trillion. That doesn’t mean a recession isn’t possible, as one can be caused by exogenous events, but it isn’t going to be caused by monetary or fiscal policy that is too tight.
It’s also worth noting that while the curve inverted in December, the new claims for unemployment, at 202,000, just hit the lowest level since December 1969 (almost 50 years ago); employment rose 196,000 in March (producing a three-month average of 180,000); and average hourly wages for private-sector workers grew 3.2% from a year earlier!
