Short And Sharp: Should We Fear The Flattening Yield Curve?

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Includes: BIL, CLTL, DFVL, DFVS, DLBL-OLD, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, FTT, GBIL, GOVT, GSY, HYDD, IEF, IEI, ITE, OPER, PLW, PST, RISE, SCHO, SCHR, SHV, SHY, SPTL, SPTS, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UST, USTB, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Principal Financial Group

By Seema Shah, Global Investment Strategist, Principal Global Investors

The trade war may have dominated investors’ fears in recent months, but there’s a new worry in town: the flattening treasury yield curve. The curve, which is measured as the spread between 2- and 10-year treasury yields, has been flattening for the past 18 months and has now fallen to around 25 basis points, the lowest it’s been since 2007. Since the 1960s, every time the spread has turned negative - an inversion of the yield curve - a recession has followed. It’s no wonder many investors are alarmed.

Yet, does an inverted yield curve cause recession, or is it simply indicative of conditions that are typically followed by recession? It’s a little of the former and much more of the latter.

The causal element is minor: as the curve flattens, bank interest margins are squeezed, their profitability declines, and the ensuing deterioration in financial conditions weighs on the economy. By contrast, the correlation element is strong. Traditionally, short rates exceeding long rates has been a simple reflection of market concerns for a future economic slowdown. Expectations for future Federal Reserve (Fed) cuts in response to the slowdown would push the long-end below the short-end in that way, an inverted yield curve does not necessarily signal a recession, but it has tended to reflect investor concerns about future economic trouble.

Since markets are meant to be the best forecasters in the business, shouldn’t we worry about the recession signal? And shouldn’t the Fed stop hiking and look to stop yield curve inversion? I would say no to both.

Several structural changes to the market have made the yield curve a less reliable indicator of impending economic doom. Normal market signals have been distorted by deflationary pressures from globalization and technology; the fall in the “neutral” long-term interest rate, regulatory changes, and huge central bank asset purchases repressing long-term yields. As a result, it now takes a smaller increase in short-term yields to invert the yield curve. Investors need to focus on fundamentals, and most economic indicators suggest the economy is in rude health.

On top of that, it would be a policy error for the Fed to stop tightening simply to avoid inversion. Overheating would inevitably worsen, and they would ultimately have to deliver even more tightening, leading to a greater risk of recession... and an even greater curve inversion.

From an equity investor’s perspective, the flattening yield curve shouldn’t ring alarm bells - even if the historical relationship between inversion and recession were to hold true. Between 1995 and 1999, the yield curve remained close to flat, yet equities continued to enjoy a strong bull market. Historical cycles show that equities did not tend to peak until almost a year after inversion.

Finally, I wouldn’t presume an inversion is inevitable. After all, there are several factors lurking on the horizon that could push up long-rates: a more hawkish European Central Bank once President Draghi’s term ends, an easing of trade tensions, the Fed’s balance sheet shrinkage, and of course, the ever-expanding U.S. budget deficit. One day that monster will show its teeth, and then investors really should be scared.