March 22, 2019: forgoing concerns of liquidity risk, investors flooded into longer-maturity bonds, inverting the 3-month, 10-year Treasury yield curve for the first time since 2007.1 Since then, it’s teetered back and forth, dipping to -0.28 on June 3. Historically, the dreaded inversion has been a telltale indicator of pending recession, but questions remain regarding its validity in today’s economic and monetary environment.
Breaking down a yield curve inversion
Bond yields move on investors’ bets and the Federal Reserve’s choices. Inversions are unusual as investors typically aren’t willing to earn less interest income on money they commit for a longer time period. It usually happens when investors expect yields on shorter-term maturities to fall substantially through Fed rate cuts, which can potentially pull down longer-term bond yields as well. This dynamic tends to occur when a downturn is near.
Yet, as you will read, most economic indicators don’t put us on the brink of collapse, there’s little talk of a repeat of 2008, and the Fed’s mixed messages are keeping its long-term rate goal cloaked in uncertainty. In this environment, while a cause to monitor, here are three reasons why we believe this inversion may not signal an imminent recession.
The market isn’t always that wise
A yield curve inversion doesn’t cause a recession. It’s a snapshot of the market’s current wisdom. After a long bond boom and a short hiccup of tightened monetary policy that didn’t substantially lift long-term yields, investors may be a bit skittish as the current cycle reaches record length.
This inversion also suggests that the market is banking on a return to loose monetary policy – no more hikes this cycle and cuts in the short term. The rationale is a need to proactively stimulate the economy ahead of further U.S.-China trade war uncertainty. There’s a major flaw in the market’s theory: it’s almost always wrong about the Fed’s next policy move. It was bullish on rising short-term yields coming out of the 2007-2008 Recession, yet the Fed artificially kept rates low to spur growth. It was then convinced that the Fed would pause or even cut rates back in 2017-2018, yet the Fed remained undeterred to find a “normal” benchmark rate, triggering short-term market volatility following each Fed hike.
While the market’s record is full of blemishes, wages tend to more accurately forecast the Fed’s path. As long as the job market remains strong, that may pressure wages and perhaps prompt the Fed to return to hikes – not cuts – before the cycle ends. However, it appears in the short term, cuts are happening. We caution the Fed to avoid sustained rate cuts in the hopes of rising inflation.
Today’s monetary environment is unique
Adjusting short-term interest rates is a key tool at the Fed’s disposal. When the economy falters, the Fed tries to encourage growth with lower rates. When the economy strengthens, the central bank pushes rates higher to curb inflation and give itself wiggle room for the eventual cuts it will need when the cycle turns.
Yet, the unprecedented 2007-2008 Recession required an equally unprecedented Fed response. It implemented basement-level rates and inflated its balance sheet to over $4 trillion in an effort to boost economic growth. This left the central bank in a precarious position once the economy recovered, far away from neutral rates with a difficult job to raise rates without thwarting the growth it had helped spur.
The current fed funds rate sits at 2.25 percent-to-2.50 percent, a low level late in the cycle. The Fed has historically required about 500 basis points of cuts to reignite the economy in a downturn, but now it doesn’t have that rope. It may be less inclined to substantially cut rates now (or at least it should) unless an emergency requires it. And it may be managing/hoping for a softer landing that requires less cuts in response.
Also, over the last decade or so, global central banks have taken bigger positions in Treasuries, compressing longer-term yields. This is likely supporting a flatter yield curve.
The economy is still strong
By ignoring the cable TV chyrons of doom, you will find that the economy is still relatively strong. ISM, which is a survey of purchasing managers who are at the frontlines of our economy, remains in expansion mode. Consumer conference, as measured by the NFIB Small Business Optimism Index, recently hit its best number since last October, wages are up, and job creation remains at or above expectations for this stage of the cycle.
Yet, a fair-and-balanced view does show some cracks. Amid trade tensions, the economy added just 75,000 jobs in May, well below the 185,000 forecast, yet it recovered to add 224,000 jobs in June.2 It’s best to view the economy through a late-cycle lens. This isn’t 2017, but it’s also not a flashback to the days preceding the Great Financial Crisis.
The facts tell us to monitor, not panic
By avoiding a theory about the yield curve inversion in isolation, you can invest with caution instead of panic. If history is any guide, the markets may be mispricing duration risk and miscalculating the Fed’s next move, while the central bank is in a somewhat unprecedented position of navigating a late cycle with a low benchmark rate. And even if a recession does occur, the inversion may not have been predictive. Cycles can die of old age, and markets are pricing in a nearly equal risk of a political or economic event causing a sudden contraction.