Notes on the week aheadContributor Dr. David Kelly
The Message from the Yield Curve
In days of yore, the sight of seagulls wheeling over an inland forest or fields was taken as a sure sign of a storm at sea. Looking at it from the seagull’s perspective, there are no fish in forests or fields – so the only reason to be inland is to avoid something dangerous out at sea. In a similar vein, last week, many investors took the sight of an inverted yield curve as a sign of impending recession.
Attention this week will be focused on Jay Powell’s speech at the Annual Jackson Hole Fed retreat. In it, he will likely try to deliver three somewhat discordant messages, namely, acknowledging the recent market volatility and signs of even slower global growth, hinting at further Fed easing in the months ahead and reassuring the public that the U.S. economy is still in good shape.
His job wasn’t made any easier by global bond markets last week, as long-term yields fell around the world and the Treasury yield curve briefly inverted between maturities of two and ten years, which many have taken as a sign of impending recession.
However, to understand what the yield curve is really telling us, there are at least five key points that investors should recognize, namely:
- Why an inverted yield curve has predicted recession in the past,
- Why it may not be such a good predictor right now,
- How other factors are pointing to slower economic growth,
- How an inverted yield curve doesn’t actually hurt the economy, and
- How low long-term interest rates, while not boosting the economy, are supporting the stock market.
On the first point, the reason a negatively-sloped yield curve has been a good predictor of recession in the past is because it tells us something ominous about what investors expect from the Federal Reserve.
To see this, it is important to understand why the yield curve normally slopes upwards, that is to say, why interest rates on long-term bonds are normally higher than on short-term bonds.
The simple reason is that they are riskier. When interest rates rise, bond prices fall but they fall more for long-term bonds. For example, if two-year yields suddenly rose from 2% to 3%, the holder of a two-year note would suffer a capital loss of just under 2%. However, if ten-year yields jumped from 2% to 3%, the holder of a ten-year bond would lose over 9% of their money. While short-term interest rates are a little more volatile than long-term rates, the difference isn’t nearly enough to compensate for this difference in interest-rate sensitivity. So long-term bonds are riskier than short-term bonds.
But if this is the case, why would anyone willingly accept a lower yield on a long-term bond than they could get on a short-term bond? The simple answer is that they must expect interest rates to fall, giving them a bigger capital gain on a longer-term bond. And why would they expect interest rates to fall? Probably because they expect the Fed to ease monetary policy. And why would people expect the Fed to ease? Because they think the Fed is worried about recession – and when the Fed is actually worried about recession, recessions frequently appear.
While this has worked well as a predictor in the past, it may be less reliable today. The reason is that, in recent years, global central banks have been buying up long-term government bonds in order to reduce long-term interest rates. This, combined with mandates that force some institutional investors to buy long-term bonds and a general glut of savings pouring into the bond market is putting greater downward pressure on long-term rates than has been the case for most of modern economic history.
So, while the yield curve traffic light is flashing orange, it may be malfunctioning.
However, there are other signals which, if not predicting recession, are certainly portending slower economic growth.
First, there is the continuing slowdown in the global economy. 2nd quarter real GDP growth was negative in Germany, Singapore, Hong Kong, Sweden and the UK. Meanwhile, Chinese data continue to disappoint, with weaker-than-expected July readings on credit growth, industrial production, investment spending and retail sales. With the global economy still facing the risk of a hard Brexit, a Japanese sales tax hike and on-going trade tensions between the U.S. and China, a rapid recovery in global activity seems unlikely, hampering U.S. exports. This week’s PMI data for the U.S., Japan and the Eurozone should confirm general global weakness.
Second, U.S. business fixed investment, having surged in late 2017 and early 2018 in response to the 2017 tax cut, has slowed sharply since and actually declined in the 2nd quarter. While this is a problem for demand in the short-run, it also is a problem for supply in the long run as it is undermining any hope of a sustained surge in U.S. productivity growth.
Third, typically cyclical sectors in the U.S. economy are showing very little momentum. Inventory growth remains above average and will likely slow going forward. Meanwhile, very slow growth in the working-age population is continuing to drag on housing and auto sales as well as labor supply.
Even with all of this, the probability of a U.S. recession starting in the next 12 months is still likely below 50%. Precisely because there is no boom in any U.S. cyclical sector, it is hard to generate enough of a drag on the economy to precipitate two negative quarters of real GDP growth. However, there is clear evidence of a slowdown to a roughly 2% pace from almost 3% in 2018.
It should also be noted, incidentally, that there is little reason to believe that a flat or inverted yield curve actually causes slower economic growth any more than inland seagulls cause storms. In theory, higher short-term interest rates ought to boost consumer interest income while lower long-term rates could boost housing and business fixed investment.
In practice, however, the shape of the yield curve is likely having little effect either way. Even with lower long-term rates, short-term rates are falling eating into consumer income. Meanwhile, given very low long-term interest rates in recent years, it is unlikely that many potential borrowers were hesitating to invest or to buy a home because interest rates were just too high.
Finally, while an inverted yield curve may not impact the economy significantly, very low long-term rates are supporting the stock market. On Friday, the 10-year nominal Treasury bond closed at a yield of 1.55%. Given that the current core CPI inflation rate is 2.21%, unless investors truly expect inflation to collapse and stay down over the next decade, this likely represents a negative real return. Making it even clearer, the 10-year TIP yield closed at 0.01% - in other words, in real terms, investors are guaranteed to receive $1 in annual interest income for every $10,000 dollars invested today. Even this seems generous relative to long-term German and French bond yields which are significantly negative, guaranteeing underperformance to cash stored in a safety-deposit box.
This further lurch down in yields has been quite sudden. A month ago, the nominal 10-year Treasury yield in the U.S. was 2.13%. However, the result in financial markets is to starve investors of alternatives to stocks. As has been the case throughout this expansion, monetary policy has supported markets far more than the economy.
For investors, this makes for a challenging environment. The risks to the economy are real and do argue for more conservative positioning. However, the ruinously low interest rates on long-term bonds around the world and central banks competing with each other on how radical they can be in cutting short-term rates is making both cash and fixed income increasingly unattractive. For now, this suggests maintaining a mild overweight to equities – but with an increasing attention to recession warning signs, in case the current soft patch turns into something more sinister.