The Bond Yield Curve as an Economic Crystal Ball

by: Richard Shaw

Generally, an inverted (negative slope) bond yield curve portends a slowing of the economy. Some people believe that the yield curve gives somewhat earlier signals about the economy than the stock market.

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The tendency for an inverted yield curve to precede a slowing of the economy is consistent with prevalent reduced analyst earnings growth estimates for the major stock averages.

Normally, the yield curve is positively sloped to compensate investors for the greater uncertainty about future conditions such as inflation. An inverted curve is much less frequently the state of affairs than a normal positively sloped yield curve.

If the yield curve is something of a crystal ball, what might it be saying?

Bond Guru Bill Gross in his January letter reads the crystal ball as indicating softening economic conditions and the need for the Fed to reduce short term rates within six months.

He points to the +5% cost of short-term debt and the risk of only a 4% GDP growth that could be difficult for business, and that would cause housing and stock prices to move lower. Therefore, he sees, the Fed needing to adjust short term rates to a level not greater than the GDP growth rate to avoid further contraction in housing and a fall in stock prices.

Gross indicated that in the last 15 years short term rates have exceeded GDP growth three times and that each time stock and/or housing prices have fallen. He explains the cause this way:

The reason is that whenever the cost of capital (Fed Funds) moves above the return on capital (Nominal GDP) then assets dependent on leverage (stocks, houses) suffer negative or more restrictive cash flows and are liquidated at the margin.

He finds that short term rates need to be 100 basis points or more below estimated forward GDP growth to be supportive of the economy. Since he sees a 4% GDP growth, he sees 3% short term rates as necessary. A big question mark is whether individuals will “take the bait” and buy homes when short-term rates go down. He does not address whether he expects long rates and mortgages to fall, or whether he simply expects improved economic growth from lower short-term rates to resolve into house buyer confidence to buy at current mortgage rates, which really aren’t very high at around 6%

He concludes:

“… if it [the Fed] lowers rates sometime within the next six months then the U.S. bond bull market will gain renewed vigor.”