The Yield Curve Is Not Signaling A Recession

by: Branson Hamilton
Summary

The Yield Curve is not inverted. In fact, by historical comparison, it isn’t even close to being inverted.

Inverted curves have typically led prior recessions with enough time that while the inversion of the curve is a warning, it is not an immediate timing indicator.

If anything, the curve is telling us that a recession is not imminent.

Let’s look at some charts to put the “inverted yield curve” in perspective.

Hardly a day goes by without someone in the financial media talking about the flattening yield curve. By now we have all read or heard that most recessions in recent history were preceded by an inverted yield curve. The news media has been flogging this theme for months as evidence that the end of the Bull Market is near (queue a drawing of The Grim Reaper).

But the fact is that the yield curve is not inverted. It may be flattening, but there is no correlation between a flatter yield curve and imminent recessions or market crashes.

If anything, “the curve” it is telling us that we have quite some time before difficulties should emerge.

Other authors on this site (including Lance Roberts) have shown the high correlation of an inverted curve to recessions. The commentary and charts below should help us to put this “inverted yield curve” into perspective including what the curve is, when it is inverted and where the curve is today as compared to the most recent inversion period.

First of all, what is the “Yield Curve”?

The yield curve is a graphical plot of the interest rate yield of bonds with different maturities. Commonly this would be a plot of the U.S. Treasury Bond yields from shorter-term maturities of 3 months or 6 months to longer-term maturities of 20 years or 30 years. In a normal market environment, the curve would be upward-sloping because typically the interest rates paid on shorter-term bonds are lower than for longer-term bonds.

Where are we today?

The Treasury Yield Curve is currently upward-sloping – short-term rates below long-term rates, as shown on this graph.

Source: as for all similar charts in this article, Data from U.S. Treasury

What is an Inverted Curve?

An “Inverted Curve” is a yield curve where the shorter-term rates are above the longer-term rates. Historically, this has happened only when the Fed has raised the Fed Fund Rates to banks to pressure short-term rates upward.

This is what an Inverted Curve looks like – short-term rates higher than long-term rates. This graph shows two dates in 2006 and 2007 where shorter-term rates were higher than intermediate rates out to the 10-year rate. The 2007 line shows that the six-month rate is even higher than the 20 and 30-year rates.

Source: Data from U.S. Treasury

The media is correct that the curve has been flattening recently. Below is a graph with curves from January of 2016, 2017 and this year, 2018. Clearly the January 2018 curve is flatter than during the previous two years. However, it is also clearly upward-sloping and far from being inverted.

Source: Data from U.S. Treasury

The yield curve saw a similar flattening process in the years before the 2008 recession and stock market crash. The graph below shows similar upward-sloping curves during the growth years of 2003 to 2005

Source: Data from U.S. Treasury

In fact, the slopes of the curves at that time are quite similar to what we are seeing today; with July of 2005 curve almost parallel to the curve from January of this year as can be seen in the following graph.

Source: Data from U.S. Treasury

It is worth noting that July 2005 was nearly 2 ½ years before the stock market peak and three years before the most severe part of the stock market crash in 2008.

I’d like to highlight another observation regarding these two periods of curve flattening. The short-term rates moved upwards but the longer-term rates held relatively constant. This is a factor that we need to pursue in our thinking about how this rate cycle will evolve. There is a belief promoted in the media that long-term rates will rise proportionately with the shorter-term rates. A look at history shows that this has not been a given in the past. And, it is this rate compression that is the cause of the inverted curve.

What drove the rates up in the 2000’s?

The answer is simple: The Fed raised the Fed Funds Rates significantly beginning in mid-2004 to combat what it saw as rising inflation, particularly in the housing market.

Source: Federal Reserve Bank of St. Louis

The Fed raised rates by 4.25 percentage points quickly in two years forcing short-term rates up. By the time of the 2005 yield curves shown above, the Fed had raised rates more than 2% from the initial 1% rate at the end of 2003. Then, within the next single year the Fed continued to increase rates another 2.25% by mid-2006.

This rapid increase in Fed Funds Rate pushed the short-term rates up to where they converged with longer rates by January of 2006. The Yield Curve then stayed inverted until mid-2007 as can be seen in the graph below where the 6-month rate (red line) is above the 5-year and 10-year rates through that period.

Sources: US Treasury and Fed

In the market/economic cycle ending in 2008, the Fed began raising rates more than three years before the stock market peak and nearly four years before the 2008 market crash. The yield curve in July of 2005 had a similar slope to today’s curve. July of 2005 was nearly 2 ½ years before the stock market peak and three years before the 2008 market crash.

The yield curve inverted by January of 2006, six months after July, and nearly two years before the stock market peaked. While there has been a correlation between an inverted curve and future recessions, this big gap between inversion and recession should show us that it is not a good market-peak timing indicator.

What might this tell us about our current near-term future?

In this current market/economic cycle, the Fed held the Fed Funds Rate at 0.25% from December of 2008 until December of 2015. In that month it began raising rates with the first increase to 0.50%. From December 2015 through March 2018 the Fed raised the Fed Funds Rate a total of 1.5% to the current rate of 1.75%. Current consensus is that the new Fed Chairman, Mr. Powell, may raise rates up to three more times this year.

The Fed began raising rates 2 ¼ years ago. The Yield Curve is not inverted today. Our situation is essentially as in 2005 of the last cycle when the economy was still growing and expectations were quite buoyant. In the last economic cycle, the Fed raised rates 2 percentage points in the subsequent year. In this cycle the expectation is that Powell may raise rates 0.75%.

While the numerical increase would be significantly less, there is more to the picture. The 2% increase then was enough to push short term rates to equal long term rates, inverting the curve. A 0.75% increase in the Fed Funds Rate from today’s 1.75% would still leave the short term rate at 2.50%, below today’s current 10-year rate (ranging between 2.74% – 2.81% this week). The curve would not be inverted at that point if the long term rates continue to be relatively stable.

We can’t predict what events might occur to change economic conditions that affect longer-term rates. What we can say from this assessment is that on the current pace, the Fed will not be causing the Yield Curve to invert this year. And, we can note from the last cycle and from data of other cycles that a stock market peak and a recession would, once the inversion happens, be several quarters, even years later.

Therefore, based on the yield curve, we should not be expecting the economy or the stock market to be rolling over in 2018, and probably not even in 2019. And, if the Fed maintains a very moderate pace of rate increases, the expansion could continue much longer. Of course, such a future would require many other factors beyond the Fed to align. Political behavior, government deficits, large volumes of projected government bond sales and geographic events will probably make a simple forecast quite irrelevant.

With that said, it is still the case that the Yield Curve is not inverted, that at the current pace of rate increases it will not cause it to invert in 2018, and that past stock market peaks and recessions occurred well after the yield curve inverted. Therefore, the current yield curve is not a reason to be negative on 2018.

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.