The yield curve has been a very dependable tool. It's not exactly as dependable as 'one if by land and two if by sea' but almost. The curve steepens ahead of economic speed-ups and flattens ahead of slowdowns and very consistently it inverts ahead of recession: signal, signal, signal; check, check, check. A number of yield curve measures can serve to provide these sorts of signals, each one will be slightly different in nature. We plot two here.
This time it's different: the yield curve signal won't work
And so in this cycle we have these famous words being pressed into service again, 'this time it's different.' What's the problem? First, the Fed and other central banks have muddied economic signals by making large scale asset purchases (LSAP). Second, the Fed actively TRIED to twist and to distort the yield curve with its purchase pattern. Third, central banks holdings of these assets have remained large. A fourth factor has come into play and that is the super low or negative rate policies overseas that have launched a global hunt for yield. Warning! This hunt is not like an Easter-Egg hunt on the White House lawn. For one thing, there is no assurance that there is anything hidden to be found. For another, the hunt will not occur in a nice supervised and protected environment; this hunt could prove dangerous to your portfolio.
These arguments are being used as reasons to set aside the yield curve signal that points to economic slowing from a flattening yield curve. A number of commentators now argue that U.S. rates and the yield curve have become disconnected from the US economy. They are artifacts of yield distortions stemming from overseas policies.
The boundless boundaries of the zero bound
Despite these concerns it may be that the monetary situations from overseas are actually blunting the yield curve signal in a different way than what is being appreciated. It is clear that the US yields are being pushed lower by monetary events overseas through the Easter-Egg yield hunt effect. Such low rates may make the U.S. economy look weaker than it really is. But what is less clear YET TRUE is that with rates so low and getting pushed lower, it gets harder to get the yield curve to invert. It is entirely possible that the yield curve signal is actually being smothered by events from overseas that are driving yields low and interfering with the mechanism that otherwise might invert the yield curve in the US to create its typical recession signal. The lower that rates get, the harder it is to achieve inversion! This is an aspect of the zero bound that you don't hear discussed- at all. Most assume that the rate signal is distorted because it flags the economy as weaker than it really is, but what if that is only part of the story?
The yield curve mechanics...Fore! Ground under repair NO free drop
Bond yields are used in a variety of ways to create signals about economic performance. With inflation-protected securities (OTC:TIPS), treasury yields are used to gauge expected inflation; meanwhile the curve's steepness is used to handicap growth. The yield curve itself most directly embodies interest rate expectations. If you have a 10-year note and a five year note with a few simple, reasonable, assumptions you also have a good estimate of the forward five year yield. That yield refers to the five year note yield that will exist five years into the future. Thus the yield curve embodies future rate expectations. The chart shows a history of the yield curve and on that history it's clear that the yield curve was the most inverted in the early 1980s when treasury-note and Fed funds yields were extremely high. When yields are high it is easy for the market to see that economic slowing will lead to lower inflation and lower rates ahead and to invert the yield curve sending long term yields down below short term yields. But in the current environment with the 10-year note yield at an all-time low yield and Fed funds barely up off their zero bound, there is much less room for the yield curve to invert on the idea that an economic slowing will bring rates down even more or that the Fed will lead rates lower with rate cuts when the Fed may only have one rate-cut left in its bag of tricks.
Too much noise not enough signal
Since the most consistent signal for recession from the yield curve is an inverted curve it is entirely possible that the transmission of monetary effects from abroad, in tandem with the proximity of the lower bound, could have undercut the ability of the yield curve to invert and to signal recession. The current popular argument is that low rates in the U.S. are creating a signal of distress that is unrelated to the condition of the U.S. economy. That may be true, but that same impact may be disguising or blunting thus nullifying the signal that the yield curve might otherwise try to send by standing in the way of yield curve inversion. My argument is that foreign monetary policy distorts U.S. interest rate signals in TWO DIFFERENT and OPPOSITE directions; it does not just bias them to make the U.S. economy look weaker.
Driving in the fog
So where does all this leave investors? Answer: confused and with less to go on than usual. Some may continue to use the same investment tools and signals but in truth they are no longer reliable. Market signals are being distorted and have been distorted by central bank actions and now by extreme central bank actions which are further contaminating the environment for market signaling. It's like trying to read smoke signals in the middle of a forest fire. At the same time central banks seem to be impotent and are not in a position to provide much guidance themselves. Yet they are trying to do something and trying not to look the impotent creatures that they have become. This actually adds to the confusion; we have gotten some pretty bad guidance from central banks recently. Moreover, central banks seem to be confused about what to do next.
Overall economic policy-making is confused and asset flows distorted
Policy at a grander level is off kilter. It's not just central banks. Central banks have been drawn into the vortex by trying too hard to keep their economies from being sucked into the black hole that they now are slipping into. It's become like a bad Star Trek episode. ("I need more power Scotty"..."I'm given' yah all I have captain!") And now it could get worse and without any of the usual warnings. This is a prescription for defensive investing not for bottom-fishing or dip-buying because there is no telling where the bottom will be or when it might fall out. If the economy is too weak to make economic investment (look at real investment in GDP or at durable goods orders) then how can it be such a great time for financial investment? Low rates are simply pushing waves of money into the least bad places propping up markets… like the stock market. Low rates may make the economy look worse than it is, but waves of low-rate-fleeing money are making stocks look better than they ought to look. Those kinds of any port in a storm flows do not make asset allocation optimal. Call it a bubble, a dislocation, or whatever you like...but broken signaling mechanisms and distortions are breeding more distortions. As far as I am concerned the markets are speaking Greek to me and I am confused by it. I will be placing more emphasis on REAL SECTOR signals and LESS EMPHASIS on financial market signals because of these anomalies.
Maybe you should too.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.