Swedroe: Reading Inverted Yield Curves

As is almost always the case, investors have plenty to worry about. If concerns about a trade war weren’t enough, the financial media has been filled with talk surrounding the risks presented by the flattening of the yield curve.

Adding to those concerns is that the Federal Reserve has begun to reduce liquidity by unwinding its massive balance sheet.

Articles highlighting these issues have led to a lot of questions from investors and advisors who have become concerned about the possibility, if not the likelihood, of the Treasury yield curve actually inverting. The reason for the concern is that the slope of the yield curve historically has been a good recession predictor.

What Inverted Yield Curve Signals

Specifically, when the curve is inverted—that is, the yield on three-month Treasury bills is greater than the yield on the 10-year Treasury note—a recession is likely in the near term.

It is important to note that similar signals can be observed if the two-year Treasury note replaces the three-month Treasury bill. In other words, the signal is robust to various definitions, providing confidence that it is not likely to be a random outcome or the result of a data-mining exercise.

You can see evidence of this in the following chart, which depicts the most recent recessions (in gray) plotted against the yield spread between two-year Treasury notes and 10-year Treasury notes.

Fed Pushing Rates Higher

The concerns about an inverted curve arose because the Fed has continued to push the federal funds rate upward. Its current target rate is now 1.75-2%, and that has pushed the three-month Treasury bill rate to 2%. With the current 10-year Treasury note rate at 2.89% as I write this on July 20, that means there is still a gap of almost 1 percentage point before the curve would invert.

It’s certainly possible, if not highly likely, that if the Fed continues to raise rates this year (it has signaled the market that it expects to continue to gradually increase rates, and the market now expects one to two more 25-basis-point increases, pushing the federal funds rate up to 2.25-2.5%), all yields could rise, not just the yields on the short end of the curve.

Thus, we are still quite a ways from the curve inverting, at least based on the traditional measure of the three-month Treasury bill to 10-year Treasury note spread. So, why is the market so concerned?

Predictive Signals Before

The main reason is that, as I previously noted, the inversion signal has worked pretty well when using the two-year Treasury note to 10-year Treasury note spread. As I write this, with the two-year Treasury note yielding 2.59% and the 10-year Treasury note yielding 2.89%, that spread is just 0.30%. That is down from about 1.25 percentage points when the Fed began its rate-hike cycle in December 2015. That makes an inversion more likely than when we looked at the spread using three-month Treasury bills.

Those investors tuning in regularly to cable financial news are hearing persistently about that two-year Treasury note to 10-year Treasury note spread. (Note: The financial media in general needs you to worry or you wouldn’t feel the need to “tune in” all the time.) With that in mind, I thought it would be helpful to provide some perspective, which might help investors avoid hitting that panic button.

Don’t Panic

To begin, it is important to understand that what matters is not just the relative level of interest rates, but also 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.

Fed Policy Accommodative

The latest forecast from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters is for inflation to be 2.5% in 2018. With the current three-month Treasury bill rate at just 2%, we have a real three-month Treasury bill rate of just 0.5%, well below the historical average of 1.3%. Clearly, monetary policy is still highly accommodative and supportive of economic growth.

As long as the real federal funds rate remains at relatively low levels, and it is negative relative to the five- and 10-year Treasury notes, investors should temper any concern they have about an inversion in the yield curve.

Another reason investors should not focus on the possibility of an inversion relates to the fact that the flattening of the yield curve has mostly occurred at the longer end. While U.S. interest rates are well below historical levels, they are now well above those of most other developed countries.

US Yields Attractive

For example, the yield on 10-year U.K. gilts is just 1.23%. The yield on 10-year German bunds is just 0.37%. The yield on Japanese 10-year government bonds is just 0.03%.

Those low yields lead the U.S. Treasury bond market to attract capital, suppressing our longer-term yields and flattening the curve. Normally a flattening of the yield curve might signal that the market is expecting weaker economic growth. However, today that flattening could just as likely be a result of “safe-haven demand” (capital flows to the U.S., as our economy is less likely to be negatively impacted by a trade war) and the global search for higher yields.

Another important point to consider is that if the yields on longer-term bonds, such as the 10-year Treasury note, continue to remain low, perhaps causing an inversion in the two- to 10-year Treasury note yields, it’s quite possible such an event could concern the Fed that lower long-term rates are a signal from the market warning about slower economic growth.

Forcing The Fed To Act?

In turn, that could lead the Fed to slow its policy of hiking short-term interest rates, which would reduce the risk of a recession.

In fact, at the Federal Open Market Committee’s May meeting, some of the governors expressed this concern. According to the meeting’s minutes, “several participants thought that it would be important to continue to monitor the slope of the yield curve, emphasizing the historical regularity that an inverted yield curve has indicated an increased risk of recession.”

It’s also possible lower yields may be attributable to a lower neutral interest rate and low term premium (the additional return required by investors as compensation for the additional risk of holding longer-dated bonds) because of more stable inflation expectations than in the past.

There’s one other point to consider regarding the possibility of an inversion of the yield curve. As the Fed continues to unwind its more than $4 trillion of balance sheet assets, it is quite possible the reduction in liquidity will lead to an increase in the term premium, preventing that feared inversion.

Active Hasn’t Exploited This

Finally, there’s no evidence that active managers have been able to exploit any signal provided by well-publicized evidence on the predictive nature of yield-curve inversions. If there were any evidence, we would see it in the annual S&P Dow Jones Indices versus Active (SPIVA) scorecards. But none exists, in either the stock or bond market. Remember, if information is well-known, any predictive value it contains is already built into current prices. Thus, it is unlikely you can use it to generate outperformance.

Investors fail to differentiate between information and value-relevant information, trading on what is nothing more than information that has no value. Certainly, if you hear it on TV or read it in the newspaper, it is far too late to act on it.

Summary

There will always be something for investors to worry about, which is why Warren Buffett warned that once you have ordinary intelligence, success in investing is determined far more by temperament—the ability to ignore the noise of the markets and adhere to your well-thought-out plan that incorporates the risks of negative events.

Hopefully, your plan reflects the certainty that negative events, including nonforecastable Black Swan events, will occur with a high degree of regularity, and ensures that you are not taking more risk than you have the ability, willingness and need to take. Getting that right increases your ability to ignore the noise of the market, and raises the odds that your head will be making investment decisions, not your stomach. I’ve yet to meet a stomach that makes good decisions.

Lastly, ask yourself this question: Is Warren Buffett spending even one minute worrying about a yield-curve inversion? The answer almost certainly is no, because he has said he has not even looked at, or listened to, an economic or market forecast in more than 25 years. One of the great anomalies in finance, which I point out in my book, “Think, Act, and Invest Like Warren Buffett,” is that while investors idolize Buffett, they not only fail to follow his advice, but often do the exact opposite, to their great detriment.

Post Script

My colleague, Jared Kizer, also looked at this issue. He analyzed the data and found the equity premium following inverted yield curves was still positive over the following three- and five-year periods, though a bit lower than the historical average.

For those worried about high valuations at the same time as an inverted yield curve, Jared found there was no correlation with returns when this was the case. In other words, there was no predictive value.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.