The Yield Curve Warning Sign

There is a lot of misunderstanding about a key indicator of the economy and markets.

The yield curve is attracting more and more attention. Most of the analysts drawing attention to the yield curve say it is giving or about to give a big warning to investors. I think they’re misreading the yield curve and the research about it.

The yield curve plots the interest rates on treasury bonds of different durations. For example, on Monday, 30-day Treasury bills carried a yield of 1.30%. Two-year bills had a yield of 1.96% and 10-year Treasury bonds had a yield of 2.49%. You can see the latest data for the curve at the U.S. Treasury website. In chart form, it’s here.

A normal yield curve is upward-sloping, which means the shortest-term debt has the lowest yields, and the yield rises steadily higher as the term of the debt lengthens.

What some analysts see or are warning about is a downward-sloping, or inverted, yield curve. That’s when the short-term debt has higher interest rates than longer-term debt.

The inverted yield curve worries people, because research has shown it is a very good early warning sign of a recession. A study by Federal Reserve economists found there was a greater than 90% correlation between an inverted yield curve and a subsequent recession.

We’ve had a normal yield curve since shortly after the Fed began its extreme monetary policy following the financial crisis. When the Federal Reserve began raising short-term interest rates in late 2015, longer-term rates didn’t rise much. The yield curve started to be less steep and appeared at risk of becoming flat. A flat yield curve usually is followed by an inverted yield curve.

So, that’s why people have been talking about the yield curve and issuing warnings to investors.

But let’s look at a few details.

While an inverted yield curve is a very good early indicator of a recession, it is an early indicator. Many times it is a very early indicator. There’s a lag, and often a substantial lag, between the inverting of the curve and the recession.

Consider the last three recessions, dating back to the early 1990s. An inverted yield curve did precede each recession, but always by at least 18 months. The yield curve was inverted three years before the early 1990s recession.

For an investor, the yield curve by itself isn’t a particularly useful tool. The economy can continue growing and stocks can keep rising for a long time after the curve becomes inverted.

Another reason to downplay the yield curve talk is there isn’t necessarily a problem when the yield curve becomes less steep. The yield curve has been distorted for about eight years because of Federal Reserve policy. The yield curve had to be very steep a couple of years ago because the Fed was holding short-term rates near zero. The yield curve has been flattening because the Fed let short-term rates rise a little.

Long-term rates haven’t been declining to meet the short-term rates. I’d be a little concerned if long-term rates were declining while short-term rates were increasing. That could be a sign of slower growth. But long-term rates bottomed in July 2016.

Longer-term rates have been rising since economic growth accelerated in the last half of 2017. I wouldn’t be surprised to see the 10-year yield exceed its March 2017 high sometime soon. That puts us a long way from an inverted yield curve and concerns about the next recession.

The Data

It was another week with a small amount of economic data.

The Small Business Optimism Index declined to 104.9 from 107.5. Last month’s number was a 13-year high and the second-highest ever, so the new level still indicates a high amount of optimism. The monthly average for 2017 was the highest in the 45-year history of the index.

Factory Orders were mixed, showing again that the hard data isn’t as strong as the surveys and anecdotal reports. The headline number showed a 1.3% increase, but a lot of that was volatile aircraft sales. Orders for core capital goods declined 0.2% for the month. But shipments of core capital goods increased 1.2%. The latest decline in orders might be only a pause in the rise that began in 2017.

The ISM Non-Manufacturing Index declined to 55.9 from 57.4. But the number still indicates solid growth, and most of the components of the survey were positive. This index has been way ahead of other surveys and the economy for a while, so it shouldn’t be a surprise for it to slow.

The recent steady rise in producer prices ended. The Producer Price Index declined 0.1% in December and is up only 2.6% over 12 months. Excluding food and energy, it still is down 0.1% over the month and up only 2.3% over 12 months.

The Employment Situation reports last Friday were well below expectations. Only 148,000 new jobs were created for the month. Average hourly earnings increased 0.3%, for a 2.5% increase over 12 months. The average workweek was unchanged.

The JOLTS (Job Openings and Labor Turnover Survey) was similar. The number of job openings declined a bit. Hiring also declined a little but still is near its high of the recovery. Separations and the quit rate remained around historic average levels.

New unemployment claims increased 11,000. We’ve had a big increase since the lows of late 2017. But this number can be volatile in the short-term, so we’ll have to watch to see if a new trend is being established.

The Markets

The new year is off to a strong start. The S&P 500 bounced 1.35% higher for the week ended with Wednesday’s close. The Dow Jones Industrial Average rose 1.88%. The Russell 2000 returned 0.51%. The All-Country World Index added 1.34%. Emerging market equities declined 0.56%.

Long-term treasuries fell another 1.82% for the week. Investment-grade bonds declined 0.37%. Treasury Inflation-Protected Securities (TIPS) lost 0.46%. High-yield bonds dropped 0.36%.

The dollar increased 0.17%.

Energy-based commodities rose 0.60% for the week. Broader-based commodities lost 0.41%. Gold returned 0.16%.

Bob’s News & Updates

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