Should We Care About The Yield Curve Going Forward?

Summary

• While scant attention is currently being given to the shape of the Treasury yield curve, I wondered what the future would hold.
• Depending on the maturities one examines, the Treasury yield curve actually inverted as far back as last March, utilizing the 3-month/10-year measure.
• I think it is very reasonable to assume the U.S. economy could have avoided a recession if not for this unfortunate turn of events.

By Kevin Flanagan

While scant attention is currently being given to the shape of the Treasury yield curve, I wondered what the future would hold. Certainly, there are a lot of other pressing issues making headlines, but what happens the next time the curve inverts - will it still be viewed as having the same predictive value as we have seen in the past?

Depending on the maturities one examines, the Treasury yield curve actually inverted as far back as last March, utilizing the 3-month/10-year measure. My preferred gauge, the 2-year/10-year differential, was historically flat at that time, and it didn't go into negative territory until August. Needless to say, the narrative once again centered on these inversions as potentially signaling an upcoming recession.

UST 2-Yr/10-Yr Spread

As the graph clearly reveals, the facts don't lie. Utilizing the UST 2-year/10-year spread, history shows that when this differential went negative, a recession typically ensued. Thus, the expectation from the inverted relationship of about eight months ago would put the U.S. economy on the brink of a contraction right about now, or probably within the next few months at the latest.

Well, guess what? U.S. Q1 real GDP came in at -4.8%, as reported last week. While one quarter does not fit the technical recession definition of two consecutive quarters of negative GDP, I don't think anyone would argue that Q2 economic activity will be in contraction territory as well. In fact, estimates at this point are for an eye-opening decline of anywhere from -30% to -40% for real GDP in Q2. If you were wondering, this is why my graph has already shaded in a recession coming up.

Okay, so the inverted yield curve kept up its track record of predicting recessions, right? Not so fast, my friend. During last year's inverted episode, I argued that the Federal Reserve's (Fed) buying of Treasuries via past quantitative easing (QE) operations, and a term premium, probably skewed the curve's predictive value. I was more of a proponent of wanting to see a more prolonged period of inversion with deeper negative spreads to allow for the two aforementioned factors.

By the way, that didn't happen…. Unfortunately, COVID-19 happened instead. I think it is very reasonable to assume the U.S. economy could have avoided a recession if not for this unfortunate turn of events. While growth was not "knocking it out of the park," the GDP was still humming along nicely at a +2.1% pace, and the Fed had just cut rates by 75 basis points (bps) during the second half of 2019.

Conclusion

Well, guess what? The Fed is now embarking on a QE program on steroids. Just in the last seven weeks, the policymakers have purchased an incredible $1.4 trillion in Treasuries. In other words, if you thought the Fed's balance sheet altered the historical relationship between inverted yield curves and recessions before, I can't imagine you'd think the curve's predictive value hasn't been affected perhaps permanently now…. Just some food for thought.

Unless otherwise stated, data source is Bloomberg, as of May 1, 2020.

Kevin Flanagan, Head of Fixed Income Strategy

As part of WisdomTree's Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree's existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management's monthly and weekly fixed income publications, and collaborated with the firm's Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University's Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.

Original post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Comments

[Darren McCammon]

Official Fed Notice:
"We are hereby changing the name of the Yield Curve to Yield Pretty Darn Flat. We appreciate the various suggestions in our internal naming contest. 'Yield, What Yield?' received the most votes; however, the PR and Marketing departments vetoed that idea."

[bo0bo0]

@Darren McCammon

:-)

[bo0bo0]

"Should We Care About The Yield Curve Going Forward?"

no. neither going forward, nor going backward.

[David de los Ángeles Buendía]

Hello @WisdomTree and Mr. Flanagan,

There are many yield curves, some invert before a recession and others do not but they all follow the same pattern. Early in the business cycle the yield curve is at a maximum and just before recession they are at a minimum. That minimum may or may not be negative, i.e. inverted. The United States Treasury (UST) spread between the 10 year bond and 3 month note has been is one of those spreads that does actually invert which is why it is more useful.

The cycle of yield curve slope changes parallels that of the business cycle as a whole. There is more demand for long-term credit early in the cycle and less demand later in the cycle. More importantly, the market for long-term credit is very elastic while the market for short-term credit is very inelastic. As a result small changes in demand for short-term credit causes large changes in the price, i.e. the interest rate while the price of long term credit is much more stable. It is this difference in elasticity and volatility that accounts for the fact that the difference between interest rates for short term credit and long term credit peak just before a recovery and bottom-out just before a recession. Whether the yield curve actually inverts depends on the type of credit.

Some yield curves have been shown to have inverted prior to a recession as far back as the 1890's, long before there was a central bank in the United States. Central bank actions and policy have no impact on the business cycle. When a yield curve inverts, it is the product of the maturation of the business cycle.

Recessions are inherent part of the business cycle, it is the natural culmination of the cycle. They cannot be avoided but they can be prepared for and the impacts minimized. That is the real objective monetary policy from central banks, to keep the damage caused by recession to a minimum.

[1] bit.ly/2cxaghp
[2] bit.ly/2cPm9Ny