Concerned About Yield Curve?

by Mark Bern, CFA

If you watch financial network TV or read what financial gurus have to say on the Internet you can expect to hear a lot about the yield curve in the coming months.  The fact is it will have everyone worried about the possibility of another recession.  Why?  In every instance when the yield curve inverted in modern history (since the Great Depression) when the yield curve inverted it was followed by a recession in the U.S. that began sometime between six and 24 months after the inversion occurred. 

What is the yield curve?  It is the spread (or difference) between the 10-year Treasury note and the 2-year Treasury note yields (market interest rates).  When the 2-year note yield is higher than the 10-year note yield the curve is said to be inverted.  The reasoning is simple: investors should expect to be paid a higher yield for holding a security that has a longer term to duration because so much can happen over the longer time frame, thereby increasing the assumed risk. 

When the short term rate is below the longer term rate (inverted) the assumption is that investors believe that there is more risk of economic slow down over the longer term than in the short term.  The bond market is actually more sophisticated than the equities market and much larger (about twice the size globally), as well.  So, historically the bond market is far more accurate in predicting the future of economic strength.  It has been infallible, so far. 

The key phrase in that last sentence is “so far.”  Why, you may ask?  As much as I dislike the term “this time is different” because it rarely holds true, I must admit that there are significant differences in the global (and U.S.) economic conditions than we have ever experienced before.  Therefore, by definition, this time may very well be different. 

What is Different Now

Here’s why.  There has never in history been a period of central bank coordination like we experienced over the last decade.  Short-term interest rates have been held artificially low by many central banks in Europe, Japan and elsewhere throughout the developed world.  The U.S. Federal Reserve policy is running against the current of other major central banks.  I’ll explain a little about why this is in a moment.  But Japan, Sweden and Switzerland short-term interest rates are below zero; the ECB rate is zero.  Israel’s short-term rate is set at 0.1%, Denmark and Norway are at 0.5% and Britain is 0.75% while the U.S. is at 2% and expected to rise by another 0.5% by year end. 

On the other end of the spectrum, central banks continue to buy long-term bonds and other securities with long maturities to hold long-term rates artificially low, as well.  Again, the Fed is reducing its balance sheet while others continue to increase holdings.  But, is the Fed selling long-term bonds, short-term bills and notes or is it merely allowing its MBS (mortgage-backed securities) to mature?  There is a discussion going on within the Fed ranks now about what its balance sheet asset make up should be (including its size and average maturity) at the end of the current downsizing exercise. 

The Fed’s Balance Sheet

Since the reductions are relatively small I would venture a guess that the Fed is reducing assets primarily by allowing them to mature instead of selling.  That would mean that it is probably continuing to hold its longer maturity treasury notes and bonds while letting bills and MBS mature.  The reason this is important is that the Fed, by holding on to the long-term bonds, is depressing long-term rates.  It is not alone in this effort.  Remember that several other central banks continue to buy long-term bonds and notes, also depressing the respective long-term interest rates.  It is a global financial world.  When quality of investments are similar but vary significantly in yield, institutional investors will build positions to arbitrage the differences, borrowing at low rates to invest in higher rates. 

Carry Trade Currency and Interest Rate Arbitrage

The current environment is especially profitable since it can be done at both ends of the maturity spectrum, short and long.  It is also beneficial because of currency trends.  With the USD (U.S. dollar) strengthening against other major currencies lately, big institutional investors (the only ones who can access the cheapest rates) can borrow for next to nothing in Japan and Europe and then use those funds to buy short-term U.S. treasury bills yielding 2% or more while also gaining on the currency translations. 

This situation is very unusual and has not happened before in history to my understanding.  The other thing that is different is that the economy in the U.S. is still gaining strength and the global economy is growing as well.  Generally, when the yield curve inverts the U.S. economy is beginning to slow and there are at least signs of potential recessions elsewhere in the world. 

Another difference is that the percentage of bonds issued in emerging markets that are denominated in USD is far below levels that existed prior to some (but not all) of the recessions preceded by an inverted yield curve. 

Conclusion

My point to all this is that the yield curve inversion, if it does in fact occur this time, may not be as predictive as it has been in the past.  With several major central banks continuing to do all they can to hold down long-term interest rates creating a huge carry trade by institutional investors playing the arbitrage game.  This activity holds longer term rates, even in the U.S., artificially lower than what those rates would normally be; and the Fed isn’t helping to offset this because it expects the lower long-term rates to help bolster the economy while it is raising short-term rates to help keep inflation at bay.  In the end, the bond market investors are not holding long-term rates low because of an expected future slow down in economic activity (which is the usual case for an inverted yield curve) but rather they are doing so because of the relatively low-risk profits to be gained. 

It is a different world and we should not expect the same outcomes.  Having said that, widespread perception may, in fact, cause a temporary correction in equities simply because too many fund managers, analysts and investors are bound to prepare for the inevitable (in their minds) stock market crash and recession.  I will not pretend that reality is stronger than perception.  But reality is more durable.  Therefore, if the yield curve inverts there will probably be a correction in equities but it will probably be more shallow than expected.  As the economy continues to power ahead investors will wake up and realize that the correction presents a great buying opportunity.  That is my expectation. 

So, have some cash ready to put to work when the next great opportunity arrives, probably in 2020.