With apologies to geezer rock fans and 70’s super star Rod Stewart, I’ve altered the title of Rod’s 1971 smash hit, Every Picture Tells a Story to introduce a question on the minds of most fixed income investors and economists. “What story is the yield curve telling us about the US economy and the wisdom Federal Reserve policy?”
But first let’s review some basics. “What is a yield curve?”
A yield curve is a snapshot of interest rates paid to investors for a variety of maturities captured by a line graph. The most informative curve tracks the yield of US Treasury securities ascending in maturity from 30 days to 30 years.
Yield Curves Present a Variety of “Slopes”
A normal yield curve displays gradually higher yields for longer maturities than shorter-term debt, suggesting market tranquility and economic stability.
A steep yield curve depicts a market in which long maturities pay a significantly higher interest rate than do shorter ones. Steep curves infer inflation risk born of fast economic growth and low unemployment.
A flat yield curve reflects a transitional market environment where interest rates can be nearly identical across the maturity spectrum. Flat curves serve as a flashing yellow caution light, signaling a shift in expectations for growth and inflation. We often see flat curves as the economy cycles from expansion to recession and back again.
The bond market boogie man is the inverted yield curve. Inverted curves portend danger and generally precede economic slowdowns by 12-24 months.
The two main drivers of the slope of the yield curve; Fed policy and inflation expectations.
The Federal Reserve enacts monetary policy to maintain price stability and moderate shifts in unemployment throughout economic cycles. Monetary policy generally has the most pronounced effect on short-term rates ranging from 30 days to 3 years.
Longer maturities are impacted most by expectations for future inflation. When investors fear inflation will erode the purchasing power of future interest payments they demand higher yields to compensate for the risk.
The slope of the US Treasury Yield Curve has been flattening as short rates follow Fed policy higher and long rates lag due to slack inflation. Today the yield curve slope between 2 and ten year maturities is the flattest in a decade while five to 30 year spreads are the tightest since 2007, just before the onset of the Great Recession.
What other forces are at work?
Recall the world’s central bankers cut policy interest rates to zero and below in response to the financial crisis and Great Recession. Nations have recovered from the one-two punch at differing speeds. The US emerged first and our financial system is the healthiest. Our government bond market is the envy of the world, offering both yield and safety.
Consider that the US 10-year Treasury yields 2.42%, German 10 year Bunds are paying .41% and Japan’s notes .04%.
Every uptick in long-term US rates is met with foreign demand that supports prices, keeps yields low and flattens the US Treasury Yield Curve. As the Fed pushes up on short rates investors push down on long yields. The international flow of funds may amplify curve flattening trends but doesn’t negate the message.
Flat yield curves are worrisome to some economists and investors, particularly when policy rates are rising. The US recessions in 1990, 2001 and 2008 were all preceded by flat curves that transitioned to inverted ones. Fed economists report an inverted yield curve has predicted every recession, save one, since the 1950’s.
Is the US headed for a recession?
Eventually, yes. The business cycle is alive and well. For now, the domestic economy is showing signs of reasonable, steady growth.
Two things currently confound economists. First is the lack of wage growth with the unemployment rate hovering near 4%. The second concern is the failure to reach the Fed’s target of 2% inflation.
With trillions of dollars sloshing around in reserves at corporations and banks traditional economic theory would predict demand driven inflation- too much cash chasing too few goods pushing prices steadily higher. When an economy reaches “full employment” it is assumed bargaining power shifts to labor from capital as employers compete for talent, propelling wages higher.
Neither demand driven nor wage push inflation has materialized, calling into question bedrock economic theories like the Phillips Curve and the Taylor Rule that influence Fed monetary policy and short-term interest rates. It’s important to note that both the Phillips Curve and Taylor Rule predate Rod Stewart’s 1971 smash hit and are considered by some to be “Geezer Economics”, irrelevant in today’s finance based, global, tech driven world. That is food for thought and perhaps another post.
The Takeaway
Today the slope of the US yield curve is distorted by the extreme measures taken by central bankers worldwide to combat financial disaster. The techno-global revolution has blasted holes in economic dogma. The story being told by the curve may be muddled and certainly more difficult to decipher but it should not be ignored.
In 2005, then Fed Chair Alan Greenspan explained away his failed attempts to steepen the US Treasury curve while raising short-term policy rates. His claim that excess global cash was finding a home in the long-term US Treasury market, is echoed by some today. With each rate hike the yield curve moved closer to inversion. The maestro assured the world that “the yield curve has lost its ability to forecast recession.” Two years later the global economy and financial system teetered on the brink of collapse.
