Talking About Upside Down - April 1, 2019

Anxiety about the slowing economy and weakness overseas have stoked fresh concerns, but the Fed’s newfound flexibility and expectations for continued growth at home remain a tailwind for shares.

The economic anxieties are being expressed in the first inversion of the yield curve in over a decade. What is the yield curve? The yield curve plots the interest rate on bonds with the same credit quality (such as Treasuries) but with different maturity dates.

For example, the curve is normally sloped when yields rise as maturities lengthen, i.e., a 10-year bond has a higher yield than a 2-year bond, which has a higher yield than a 3-month T-bill. But there are times when the curve inverts – longer-dated bonds have lower yields than shorter-dated bonds.

On March 22, the yield on the 10-year Treasury fell below the yield on the 3-month T-bill. It’s something that hasn’t happened since 2006 (St. Louis Federal Reserve).

Importance: the 10-year/3-month has inverted prior to each of the last seven recessions, as illustrated by the graphic below. The one glaring exception – the curve inverted in 1966, without an ensuing recession. But growth did slow considerably (St. Louis Fed GDP data).

On average a recession has occurred nearly 11 months following the inversion of the 10-year/3-month (St. Louis Federal Reserve, NBER – reviewing the last 7 recessions going back to 1969).

Ominous warning or is it different this time?

“It’s different this time” is a phrase that should set off alarm bells. Usually it isn’t. But why might we at least entertain the question?

For starters, an inversion of the 10-year/2-year has also preceded recessions. It has not inverted. The Conference Board’s Leading Index has barely risen since October, foreshadowing the economic slowdown, but it hasn’t turned lower. Historically, it has declined for 7 to 20 months in front of recessions (Advisor Perspectives).

Longer-term yields in the U.S. may be getting pulled lower by weakness in bond yields overseas. In other words, rock bottom yields overseas may encourage foreign investors to park cash in higher-yielding U.S. bonds, pushing U.S yields lower (bond prices and bond yields move in the opposite direction).

The Fed’s policy shift may also be putting downward pressure on longer yields, aiding growth.

Economics is an inexact science. We can look for patterns that may give us a peek at the future. But patterns typically aren’t perfect replicas of past events. Today, economic positives can still be found.