Yield Curve Inversion: The Complete Picture
Equity market investors should not only pay attention to company or industry-specific developments, but also to other macroeconomic developments that could determine the performance of capital markets in the future. Changes in interest rates could have a material impact on stock prices, and an inversion of the yield curve that represents the spread between 10-year and two-year Treasury yields is seen as an ominous sign. In August, this phenomenon occurred and investors were quick to conclude that an economic recession is imminent.
What does an inverted yield curve mean?
The yield curve plots the relationship between yields of various securities having the same credit quality but different maturities. The spread between short- and long-term rates correlates with economic growth, and this acts as a strong indicator that shows where an economy is headed.
An inverted yield curve occurs as a result of a higher demand for long-dated Treasury securities based on lower economic growth projections, which eventually drives the prices of such securities higher. Eventually, short-term treasuries provide a better yield than their long-term counterparts, which results in the inversion of the yield curve.
When investors are less confident about the future outlook of an economy, they seek safe-haven investments such as government bonds. Purchasers of Treasury securities are confident that the U.S. Treasury will not default on their payments. During the 2008 recession, foreign governments increased their holdings in Treasury securities. According to data from Reuters, such holdings jumped from 13% in 1988 to 31% in 2011.
When many investors turn to bonds due to increased volatility in stocks, this collective sentiment, together with the inversion of the yield curve, will be an indicator of the state of the economy.
However, an inverted yield curve alone cannot predict an imminent recession as it does not portray the big picture. Many other macroeconomic factors need to be considered.
Is the U.S. economy in bad shape?
Data released by the Federal Reserve indicates the U.S. gross domestic product grew at an annual rate of 1.9% in the third quarter of 2019, following 2.1% annualized growth in the previous quarter. This is a slowdown from the 3.1% growth recorded in the first three months of the year. The main growth drivers were household consumption and government spending. Business investments declined by 3%, recording the sharpest decline since early 2016.
U.S. GDP growth
The trade tensions between the U.S. and China are certainly not helping the American economy to break through. The 15-month-long trade war and the sluggish growth in business investments could hinder the ability of consumers to drive the economy higher in the future. Fed Chair Jerome Powell commented on this in the policy meeting concluded on Oct. 30.
"Trade policy tensions have waxed and waned, and elevated uncertainty is weighing on U.S. investments and exports," he said.
Josh Bivens, director of research at the Economic Policy Institute, wrote in a report released in July:
"There is plenty to worry about as there is a weakness in both residential and non-residential investments. The last time residential construction investments contracted for this long was during the great recession."
The economy is not in a bad shape yet, but there are signs of a slowdown. Equity markets generally react to such developments in advance, meaning that investors could be in for a surprise sooner than they project. Some of these ominous signs are discussed below.
The Fed might be caught in a liquidity trap
Many analysts polled by Reuters believe that central banks around the globe are in a liquidity trap. This occurs when an injection of cash into the private banking system fails to stimulate the economy as cash is being hoarded by investors who expect deflation and lackluster economic growth. One of the primary characteristics of a liquidity trap is short-term rates that hover just above zero. At present, the target federal funds rate is 1.5% to 1.75%.
Injection of liquidity by the Fed takes place through its open market operations. This new money entering the system would, in turn, increase the excess reserves of the major banks and go into financial assets without actually supporting economic growth. Therefore, lower rates might do very little in actually helping to stimulate growth and lead to unintended consequences such as deflation.
On the other hand, if interest rates were to rise with already weak growth, it would increase borrowing costs, the budget deficit and weaken consumer demand. Either way, the economy will take a hit, but the only difference would be that low interest rates would keep the economy up and running for a longer period of time.
Correlation between capital markets and the Composite
Source: Real Investment Advice.
Will lower rates do any good?
The Fed lowered rates by 25 basis points in October, marking the third such cut this year. Even though this dovish stance might raise questions among investors, the U.S. is in a relatively strong position compared to other countries. For example, Reuters data indicated Japan is struggling to meet its inflation targets even with negative rates, Germany is on the verge of entering a recession despite the negative rates, the Chinese economy is slowing down with the trade tensions, the European Central Bank further reduced its rates to -0.5% and 40% of investment-grade bonds outside the U.S. have a negative yield.
The short-term rates in the repo market recently shot above the unsecured lending rates, but banks were not willing to rake in these profits even at such high rates, showing less liquidity in the market. The repo market crisis that took place is evidence that the risk of a recession is heightened. It also means the big banks are hugely undercapitalized and U.S. Treasuries are not risk-free. The Fed had to intervene to inject more than $75 billion into the system in September to provide the necessary liquidity into the market.
David Morgan, the publisher of The Morgan Report that covers economic news, believes that this rapidly increasing intervention is an obvious sign of insolvency.
Traditionally low rates have been contributing positively to growth. But a recent research report ("Low-Interest Rates, Market Power, and Productivity Growth" by Liu, Mian and Sufi) shows that low interest rates will lead to slower economic growth through increased market concentration.
This report states that although lower rates are supposed to encourage firms to invest more, it only benefits the market leaders rather than small players. Consequently, industry leaders become more monopolistic as the long-term rates fall. According to the research, when the rates decline, dominant players in a market grab the opportunity by responding much faster to changes. This puts the followers far behind and discourages them from investing. A set of large companies would, therefore, build on their competitive advantages, while the economy as a whole does not receive the intended boost.
In the very short term, the decision by the Fed to cut rates will provide some boost, but it is likely such benefits would not last long.
Stagnating wage growth and debt at all-time highs
Wages for the private sector workers rose 2.9% in September 2019 compared to September 2018, which was the slowest growth seen since July 2018. The unemployment rate, on the other hand, increased to 3.6% in October 2019 from 3.5% in the previous month, which was still at moderate levels.
Jared Bernstein, a well-known economist, stated that although wages for blue-collar workers and non-managers grew by 3.5% in September 2019, this number is stagnating. Decelerating wage growth would hinder consumers' ability to spend.
Sarah House, an economist at Wells Fargo, holds the view that a meaningful strengthening of wage growth cannot be expected in the near future. Also, trade war tensions and slowing global growth have made businesses cautious abput making new investments. These developments indicate the rate cuts might not provide the intended boost to the economy.
Source: The Bureau of Labor Statistics.
The total debt in the U.S. was $22.6 trillion in September. It has increased by more than 750% from 1989 to 2019. Congress has raised the U.S. debt ceiling several times and the Bipartisan Budget Act of 2019, which was signed by President Donald Trump, will suspend the public debt limit through July 31, 2021.
Source: Real Investment Advice.
The total debt consists of public debt and intragovernmental debt, which is owed by the Treasury to the Social Security Fund and various other trust funds.
As stated by Kimberly Amadeo, the president of World Money Watch, the Social Security Fund will not be enough to cover the retirement benefits as promised and, as a result, Congress is more likely to curtail benefits than raise taxes in the future.
This rising debt burden could also lead to financing problems for the government in the future.
Is the U.S. heading toward a recession?
History suggests there is a correlation between inverted yield curves and recessions, though sometimes with a significant time lag. An inversion of the yield curve has preceded every recession that has occurred in the U.S. since 1950.
The spread between three-month and 10-year Treasuries began heading downward in 2014 and inverted for three months in mid-2019 as investors started pouring their money into the bond market. The inversion took place from June to August. This is the first time this has occurred since 2007. The curve rebounded back into positive territory in October.
Currently, the two-year, 10-year yield spread is at 0.21% and the three-month, 10-year yield spread is at 0.27%.
The past three recessions occurred within a year after the yield curve rebounded from an inversion. The negative spread in 2007 predicted a 40% chance of an imminent recession in a year.
There have been seven economic recessions since 1960, all of which were predicted by the inversion of a yield curve. This is depicted in the below graph.
Each time the yield curve went negative, the country entered a recession in about 10 to 18 months later. The general notion is that a downturn would occur within 24 months of this phenomenon.
The S&P 500 Index has historically continued to head upward during a yield curve inversion, posting positive returns. Phillip Nelson, the head of asset allocation at NEPC in Boston, says that inversions are a part of late-cycle dynamics, and they do not represent the end of a cycle. Thus, equity markets could continue to provide positive returns.
Merill Lynch analysts, on the other hand, highlight that the index has hit record highs every time an inversion occurred.
The following graph illustrates the one-year, 10-year yield spread against the S&P 500 Index.
Equity markets still seem to be doing fine at all-time highs, even with all the volatility that kicked in. But this upward momentum might not continue for long, considering the pressure on interest rates, slowing economic growth and the trade policies that people have no idea what would be like. There's a possibility of the U.S. economy entering a recession within the next five years, as confirmed by economists polled by CNBC. But it is hard to predict when exactly this would occur.
It's about preparing for the worst, but hoping for the best
For now, investors need not panic. Historical evidence suggests there are at least two years ahead of markets before a recession occurs. However, it's better to diversify portfolios by investing in defensive industries such as health care, consumer staples and utilities. Some of the most noteworthy companies representing these industries include Coca-Cola (NYSE:KO), Walmart (NYSE:WMT), Dollar Tree (NASDAQ:DLTR), McDonald's (NYSE:MCD) and Amgen (NASDAQ:AMGN). Investing in gold could also prove to be a good decision, considering its past performance during times of crisis.
Disclosure: I do not own any stocks mentioned in this article.
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This article first appeared on GuruFocus.
