Well, This Yield Curve Just Inverted - What Does It Mean?
Each economic cycle, specifically towards the latter stages when the yield curve nears inversion, there are two camps that typically emerge. One camp that finds the yield curve to be an irrelevant measure of forward economic growth and inflation expectations unless there's an inversion, and another that believes the marginal moves in the yield are meaningful irrespective of the curve remaining in positive territory or inverting. I'm in the latter camp, but before moving on and discussing what it means that the TIPS yield curve has just inverted, it's probably a good idea to recap some of the concepts that we will discuss below.
First, the yield curve is a measure of the slope between various maturities on the Treasury curve. Typically, shorter maturity bonds have lower yields and longer maturity bonds have higher yields, giving the curve, or the difference between long-term and short-term rates a positive slope.
In the latter innings of an economic expansion and often times before recessions, short-term rates can carry a higher yield than longer-term rates which gives various spots on the Treasury curve a negative slope. This phenomenon typically occurs when the market is worried about future growth and inflation while the Federal Reserve continues to raise the short end of the curve via the Federal Funds rate. This "disagreement" between the Federal Reserve and the bond market regarding future growth and inflation can result in an inverted yield curve.
The nominal Treasury curve has not inverted at any spot along the curve but there has been an inversion in the TIPS market. TIPS or Treasury Inflation Protected Securities are Treasury Bonds issued by the US Treasury that are indexed to inflation and backed by the U.S. government. TIPS are considered extremely low risk because the par value of the bond rises with inflation, measured by the Consumer Price Index. To read more on TIPS, click here.
The chart below shows five different maturities of TIPS. The 5-Year TIPS yield is currently 0.89% while the 7-Year TIPS yield is 0.88% and 0.87% for the 10-year maturity. This downward slope in the front of the TIPS curve is a yield curve inversion. The iShares TIPS Bond ETF (TIP) tracks the performance of a basket of Treasury Inflation Protected Securities. The TIP ETF has an effective duration of 7.7 and therefore will most closely track the total return of a 7-Year maturity TIPS.
There are far fewer maturity options in the TIPS market than the nominal Treasury market. Below is the full Treasury yield curve of the nominal Treasury curve for a comparison. The red line represents the Treasury yield curve one year ago and the black line is the curve today.
While the curve remains positively sloped between each maturity, the curve today is meaningfully flatter than it was one year ago.
Moving forward, when talking about the yield curve, for simplicity reasons, we will just use the spread between two maturities such as the 10-year yield minus the five-year yield for a proxy for the slope in the yield curve.
The chart on the left shows the 10-Year TIPS yield minus the five-year TIPS yield and the chart on the right shows the 10-Year nominal Treasury yield minus the five-year nominal Treasury yield.
As the chart shows, both spreads move very similarly with respect to the shape but differ slightly on the actual spread. The TIPS curve (left) inverted prior to the 2008 recession as did the nominal Treasury curve. Today, the TIPS curve has once again inverted while the nominal Treasury curve remains in positive territory yet not far behind sitting at just 10 basis points, the lowest or flattest level of this economic cycle.
Source: Federal Reserve, EPB Macro Research
What Does An Inverted TIPS Curve Imply?
The slope of the nominal Treasury curve should be alarming to investors, just 10 basis points away from inversion, but we will focus on the curve that just inverted, the TIPS curve.
The market's inflation expectations for future inflation peaked in May 2018. This is not up for debate as this can be empirically measured. The breakeven inflation rate is the market's expectation for the average rate of inflation over a given time period derived from the yield on nominal Treasury bonds and the yield on TIPS.
In May 2018, the market was pricing in average annual inflation of 2.17% over the next 10 years and 2.16% over the next five years. Those expectations for future inflation have softened to 2.10% over the next 10 years and 1.98% over the next five years on average.
Inflation Expectations Over 5-Years and 10-Years:
Source: YCharts, EPB Macro Research
These expectations have changed in part due to a slowing global economy, which we will not discuss here, as well as a global collapse in commodity prices (with the exception of oil).
Below shows the six-month change in the CRB Index, a basket of 19 commodities, as well as the CRB Index Ex. Energy, the same basket excluding oil and gas prices.
Backing out oil prices shows that the broad commodity complex has been in free fall for the better part of four months which has significantly contributed to the reduction in future inflation expectations and top in long-term interest rates.
Inflation Expectations Based On Commodities:
Source: YCharts, EPB Macro Research
Below we can look at the market's expectation for average inflation across four-time durations: 5-years, 7-years, 20-years, and 30-years.
The market's expectations for inflation peaked in May 2018 across every time horizon and has since cooled.
It is unsurprising that long-term interest rates peaked when inflation expectations were at their highest point. The 30-year yield peaked in May 2018 and has since been trading in a choppy range below the 3.25% peak.
Interest Rates Peaked When Inflation Expectations Peaked:
What we can glean from the inversion in the TIPS curve as well as the reduction in future inflation expectations is that the market fears short-term inflation more than long-term inflation.
Over the next 10 years or 20 years, the market is not fearful of inflation, expecting this current rise in inflation to nearly 3% will be offset by declining rates of inflation far below 2%, likely down to 1% which will bring the long-term average back near 2%.
Declining rates of inflation in the future are likely expected as part of a broad economic slowdown. Economic slowdowns bring out strongly decelerating rates of inflation.
Some may be quick to write off the inverted TIPS curve as a meaningless indicator, but with the nominal Treasury curve not far behind, it's best to dig deeper and understand the dynamics that are possibly responsible for this market phenomenon.
We could have just hit an inflection point in the economic cycle.
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