First of all, let’s get started by briefly describing a yield curve. Please hang with me for a minute; you will like this. Below is a graph of the yield on US Treasury securities. The yield (interest rate) is on the vertical axis and the time period is on the horizontal axis. Typically, yields are higher on bonds that mature further out in time. So, a typical curve rises from low to high as it moves across the graph from left to right.
The graph below has two curves on it: the yield curve as of today and the yield curve as it looked three years ago on December 31, 2015. As you can see, short-term interest rates have increased since 2015. However, longer-term interest rates have not increased as much.
The difference between what a 2-year treasury yields and a 10-year treasury yields is a very closely followed gap. Today, that difference is only ~0.13%. Normally, the difference between a 2-year yield and a 10-year yield is much greater. This narrowing of the difference is called a “flat” yield curve. If the gap or difference gets to where a 2-year yield is greater than a 10-year yield, it is called an “inverted” yield curve.
Okay, so enough of the economics part of this message. Now you will be able to impress all your friends and neighbors at your holiday parties with your thorough understanding of the flattening yield curve.
Many have said that the recent volatility in the stock market may be due in part to the flattening yield curve and even a brief inversion of the 2-year to 5-year spread earlier this week.
So, how can interest rates on US Treasury securities have a meaningful impact on stock prices? Well, when the gap between short-term interest rates and long-term interest rates narrows, historically, that has been a sign that economic growth may be slowing. For most of 2018, the yield curve has been flattening. With a flattening yield curve and the US economy in one of its longest economic expansions in history, it is understandable why many investors are paying close attention.
Here is a key takeaway to remember: Although every US recession was preceded by an inverted yield curve, NOT EVERY YIELD CURVE INVERSION WAS FOLLOWED BY A RECESSION.
This time around, I think it is important to look at what may be causing the flattening. Typically, a flattening yield curve happens when short-term interest rates have risen too high for the economy to handle without going into a recession. This happens when monetary policy is too tight. We all know that the Federal Reserve has been increasing short-term interest rate, and we can clearly see short-term interest rates have risen in the graph above. But, “real” interest rates (when you factor in inflation) are still near 0% today. It doesn’t seem to me that 0% real interest rates are too much for the economy to handle.
Let’s look at the longer end of the yield curve. Interest rates on longer dates have not risen much at all. You may have heard that the Federal Reserve is shrinking its balance sheet from years of unprecedented quantitative easing (QE). This is a good thing most believe and would typically cause these longer-term interest rates to rise. However, many other central banks around the world are still in the throes of their QE programs, and that would likely boost demand for US Treasuries thus keeping yields down.
So, even though the yield curve is flattening (short-term interest rates are rising, and longer-term interest rates are not), it does not necessarily indicate the economy is headed for a recession. US economic growth has accelerated this year, and although growth is forecast to slow next year, the economy is still humming along quite nicely. Household balance sheets and savings are at their healthiest levels in two decades.
Remember the key takeaway here: Every US recession was preceded by an inverted yield curve, BUT NOT EVERY YIELD CURVE INVERSION WAS FOLLOWED BY A RECESSION.
Another key point to think about is a favorite quote of mine from famed mutual fund manager Peter Lynch, who often said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
I think it is safe to assume that Mr. Lynch would say the same applies to trying to anticipate recessions as well. This is where we come in. Understand that recessions occur. They happen. They are a natural part of an economic cycle. Trying to predict, anticipate or time this cycle is risky and reckless and can lead to missed opportunities and sleepless nights.
A well thought out plan and a strategy built around your unique needs and circumstances will help you weather any recession. We can help.
If you would like to hear more about the yield curve or want a further explanation or simply have some questions, please feel free to call me our any of those on our wealth management teams.