July 2018
Fear of the Inverted Yield Curve
By Tim Courtney, Chief Investment Officer
Following the 50 percent market drop between 2008 and 20091, investors have enjoyed nearly a decade-long bull market2. But with such a long-running recovery, many have begun to wonder: When will the next recession hit?
The next recession will come in time. However, gauging when that time will come, or how bad the recession might be, is not an exact science. There have been signs, like the Hindenburg Omen3 and the Death Cross4, which attempt to predict market declines with questionable accuracy. But one such sign that has been gaining a lot of attention lately is the inverted yield curve5. This indicator flashed warnings before each of the last seven recessions6, and so is currently seen as a relatively reliable predictor of a weakening economy.
The inverted yield curve occurs when short-term bonds pay higher yields than long-term bonds. Because longer-term bonds involve more risk, this situation is at odds with the risk-return relationship. Investors should be compensated with higher yields for the higher risk. However this “inverted” yield curve shouldn’t stay inverted for long, and its existence means that the bond market believes short-term interest rates will soon fall because of approaching economic weakness.
It’s important to understand how today’s interest rates and inflation compare to recent times the yield curve inverted.
Typically, short-term rates are heavily influenced by the Federal Reserve, while long-term rates are more influenced by supply and demand of the market. With that in mind, consider the situation in the early 80s when the Fed was trying to get inflation under control from its 13.5 percent7 high. To do so, the Fed, led by then Chairman Paul Volcker, raised rates high enough to invert the yield curve on purpose with the goal of containing inflation, soon sending the country into recession8. Despite the recession, Volcker’s plan suppressed the higher inflation rates, ultimately pushing them down to the 2 to 3 percent range.
Today, inflation sits at 2.8 percent7 – not nearly as high as it was in the 70s or 80s. And while the Fed may be hoping to raise rates to stave off further inflation, we don’t face anywhere near those inflation levels. To that point, it’s highly unlikely that the Fed will raise rates significantly higher than long-term rates when inflation is only in the 2 to 3 percent range. It is also unclear that short-term rates at 3 or 3.5 percent would be high enough to discourage borrowing and stunt economic growth.
While the inverted yield curve has historically been a marker of impending recession, the interest rates and inflation are in a very different place than they were the last several times the yield curve inverted. Additionally, there are also many positive economic indicators flashing, including the unemployment rate9 and consumer confidence10 to name a couple. We’ll continue watching.
Sources:
1 Yahoo Finance – S&P 500
2 USA Today – Bull market for stocks is turning 9. Could it become the longest?
3 Investopedia – Hindenburg Omen
4 Investopedia – Death Cross
5 Investopedia – Inverted yield curve
6 CNBC – This market indicator has predicted the past 7 recessions. Here’s where it may be headed next
7 US inflation calculator – Historical inflation rates: 1914-2018
8 NPR – How former Fed Chairman Paul Volcker tamed inflation — maybe for good
9 USA Today – Can the 3.8% unemployment rate tumble toward zero?
10 CNBC– Consumer sentiment rises to highest level in three months
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