The Inverted Yield Curve: Another Viewpoint

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by: John M. Mason
Summary

The Treasury yield curve inverted last week and many got very nervous because an inverted yield curve has always been followed by an economic recession.

It seems as if the inversion of the yield curve has resulted from an entirely different set of circumstances this time requiring us to take another look at its interpretation.

My conclusion is that the economy will continue to grow and not fall into a recession, but the growth will remain quite weak.

The news coming out of the bond market at the end of the week was the inversion of the yield curve.

The concern: every time the yield curve has been inverted in modern times, the US economy has always gone into a recession.

Let me just issue a word of caution here.

We are in a new era. The past ten years have provided us with financial market behavior that has been completely out-of-sync with previous economic recoveries.

When, for example, has there been an expansion of monetary assets in the banking system inserted by the Federal Reserve that has not resulted in a major inflationary period?

We spent the first four years or so of the current economic recovery trying to explain why inflation was not bursting at the seams of the economy.

Yet here we are, ten years later with inflation and inflationary expectations running around the 2.0 percent level.

Furthermore, economic growth has never really taken off during the recovery. The annual compound rate of growth of the US economy over the past, almost eight years, is around 2.2 percent. This is the slowest expansion in US history.

Furthermore, the growth of labor productivity during this recovery has been not too far above zero, helping to account for the slow rate of growth in the economy and the slow rate of inflation.

These factors have helped to keep longer-term interest rates down as real rates of interest and inflationary expectations have remained mild.

Usually, during an economic recovery, you see longer rates of interest rising as economic growth picks up steam and as inflationary expectations come to dominate the longer-term bond rates.

You have not seen this phenomenon here at all.

What tends to happen as the economy picks up steam during the expansion is that the central bank begins to raise short-term interest rates to slow down the economy from its accelerating pace.

So, longer-term interest rates are rising along with the state of the economy, while short-term interest rates are rising faster in order to keep up with economic activity.

At some point, the pace of the economy or the speed of inflation becomes troublesome and the central bank, the Federal Reserve, begins to increase the short-term rates relative to the longer ones.

And, at some point, the central bank raises the short-term rates above the longer-term rates and you get an inverted term structure of interest rates.

In this case, the inverted yield curve is a part of the Fed’s monetary policy. It is aimed at creating a recession and, as we have mentioned, a recession, sooner or later, follows.

This is the classical cycle.

However, we have experienced nothing like this in the current situation.

Longer-term interest rates have not risen to the extent that many analysts thought they would. As mentioned, economic growth remained anemic and inflationary expectations remained below 2.0 percent. The market’s wonder here, and I include myself in this group, was that the yield on the 10-year government bond remained so low over the past several years.

The Federal Reserve raised short-term rates of interest, but the effort here was to return short-term yields to a “more normal” level, a level more consistent with the current economic growth.

In recent months, the weak state of the world economy, along with tariff discussions, the sad evolution of Brexit, and concern over the strength of the US economy, created an environment of greater pessimism. And, longer-term bond rates fell, flattening out the yield curve.

The Federal Reserve, for its part, backed off further rate increases for this year.

The Fed is not in the position where it has to “invert the yield curve” to cause a recession to stabilize the economy.

In fact, the Federal Reserve is projecting an even weaker economy, but one that is slowing because of supple-side reasons and not because of a drop in aggregate demand. In its latest projections, the Fed has economic growth at 2.1 percent in 2019, down from 2.3 percent, and 1.9 percent in 2020, down from 2.1 percent.

One should note that this projection is in contrast to the economic growth assumptions built into the budget proposals of the Trump administration. That document sees the US economy rising at a 3.2 percent rate in 2019 and then producing a 3.1 percent increase in 2020.

My conclusion from this analysis is that the US economy will continue expanding at a slow, steady rate over the next year or two, much as the Fed has projected. The reason for this is that the inverted yield curve has not been created by the monetary authorities to produce an economic slowdown or a recession.

Much as we have seen over the past ten years, the supply-side of the economy will continue to produce “low” but steady growth. The economy will not fall into a recession, unless there is a major shock imposed upon it by the world economy or Brexit or tariff wars.

I think that Jerome Powell, Fed Chair, and his team have managed this period well and, without much fanfare, has got the Fed working to support the slow but steady growth. And, this will be the picture for the future unless some other things change.

The “inverted yield curve” has not come to us in the usual way. We must adapt to the new situation and proceed on with this different environment.

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.