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.
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.