The ‘yield curve’ – the difference between the yield on the 10 year Treasury Note and the yield on the 2 year T-Note – has recently flattened to its lowest level in over a decade. This raises concerns since, as the chart below shows, an ‘inversion’ of the yield curve often precedes a recession.
There are, however, some economists and market watchers that are not too worried about the yield curve. They agree with former Federal Reserve Chair Janet Yellen who said:
There is a strong correlation historically between yield curve inversions and recessions. But let me emphasize that correlation is not causation.
They argue that, in the current market cycle, the yield curve is a poor indicator due to substantial central bank interventions in the bond markets over the past decade. This argument has some appeal. Under normal circumstances, the yield curve inverts when investors collectively decide that longer term bonds have lower risk than shorter term bonds due to near-term uncertainty in growth and inflation outlooks. Today, however, the 10 year Treasury Note (the longer portion of the curve) may be stuck in place, in part, due to foreign central bank policies that have led to exceptionally low 10 year rates in Europe and Japan. The shorter end of the curve is being influenced even more directly by the policies of the Fed, whose determinations have as much to do with policy normalization as with combating inflation. When the bond markets are rigged, can the yield curve really be an effective indicator?
While the view of the ‘yield curve skeptics’ described above makes sense, it is also limited in that it treats the yield curve solely as a gauge of economic sentiment and activity – as a symptom of an illness rather than the illness itself. Unfortunately, an inverted yield curve does have important and direct economic consequences. Higher short term interest rates means higher borrowing costs for consumers and businesses that rely upon short-term debt. This places pressure on profit margins for many businesses, but especially on banks that borrow short-term and lend longer term. Since it will be less profitable for banks to lend money, credit will be more restricted as the curve inverts. These factors have the effect of forestalling economic growth. In this way, an inverted yield curve is more than just an economic indicator.
Where does this leave investors? As usual, when faced with conflicting views that each have some validity, we advocate the common sense middle ground. During this market cycle, an inverted yield curve may not be a screaming red flag, but it cannot be entirely dismissed either. If the yield curve does invert, it should serve as a ‘cautionary yellow signal’ as the probability of an economic slowdown has increased (or, at least it certainly hasn’t gone down). Significantly, there is substantial lag (averaging around 16 months based on the chart above) between a yield curve inversion and the onset of a recession. So as the curve flattens, investors have time to look for other signals that can help assess the economic climate.