No topic has dominated the investing conversation more lately than the yield curve.
Although this is an obscure question for most people, we in the financial sphere have been bowled over by this indicator of the future health of the economy – the graph of interest yields on bonds with increasing maturities, usually risk-free Treasury securities.
But some people might swing into the wrong curve.
Typically, investors require a higher return to commit their money for a longer time frame, so the line on the graph rises from the lower left corner to the upper right corner, a positive slope in mathematical terms.
Sometimes, like today, short-term market returns exceed long-term ones, creating an inverted yield curve. The most watched version of the curve focuses on the two-year Treasury note. At 2.44% Friday midday, its yield topped the 10-year benchmark’s 2.38%. This reflects a marked shift in market expectations of Federal Reserve policy.
Over the past month, the central bank raised its main federal funds rate target for the first time since 2018 and signaled its intention to begin rolling back the emergency monetary stimulus it began in March 2020 to counter the effects of the pandemic.
The yield on the two-year note — the Treasury coupon most sensitive to changes in Fed policy — jumped 112 basis points during that time, according to Bloomberg. The 10-year yield rose 65 basis points, also a considerable increase over a relatively short period. (A basis point is 1/100th of a percentage point.)
Historically, reversals in the two- to ten-year yield spread have been associated with recessions – five of the last six, by one point. So is it time to watch the recession?
No, given the boom in the labor market. March payrolls data released on Friday showed nonfarm payrolls continued to grow strongly, up 431,000 last month after an upwardly revised increase of 750,000 in February. March’s unemployment rate fell to a post-pandemic low of 3.6% from 3.8% the previous month, and for good reason: strong job growth, which outpaced gains in labor market, which has peaked post-pandemic.
Yield curve recessions were rooted in the Fed’s tight monetary policies, which ultimately tipped the economy into a slowdown. Now, curve moves are based on anticipated rather than actual Fed actions. The central bank only began its initial takeoff from the zero percent floor last month. And it did so by just 25 basis points, just 0.25%-0.50%.
The Fed is expected (belatedly) to do more with hikes to contain inflation at its highest level in four decades. This replaced its other mandate, full employment, which is mission accomplished, according to employment figures. The fed funds futures market is forecasting 50 basis point rises at policy meetings in May and June and 25 basis point increases the rest of the year, for a December target of 2.50% to 2 .75%, depending on WEC’s FedWatch site.
This is reflected in the strong recovery of the two-year yield curve. But the spread between three-month and 10-year Treasury yields is actually the metric to watch, according to the model developed by former New York Fed economist Arturo Estrella. And this curve remains clearly positive and well outside of recession prediction territory.
Moreover, while the 10-year yield is indeed up, it is still low in absolute terms and deeply negative in real terms (i.e. after inflation), writes Paul Ashworth, chief US economist at Capital. Economics, in a client note.
Meanwhile, 10-year TIPS (Treasury Inflation Protected Securities) are trading at a real yield of minus 0.46%. Corporate and mortgage borrowing costs are also low and negative in real terms. And, Ashworth argues, even with those rates rising, slowing growth in interest-rate-sensitive sectors, such as housing, consumer durables and business capital spending, is unlikely. , “does more than dampen real economic growth a little”. .”
The notion of the yield curve as a predictor rests on the assumption that while the Fed effectively sets short-term rates with its fed funds target, yields for longer maturities are set by the market, acting on rational expectations about the future.
As Jay Barry, head of US government bond strategy at JP Morgan, points out, the Fed has acquired more than 25% of the US Treasury market through its quantitative easing asset purchases. They have inflated the central bank’s balance sheet to nearly $9 trillion, more than double its size at the start of March 2020. So the Fed’s outsized impact will continue, even as it begins to reduce its holdings.
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The classic message sent by an inverted yield curve is that financial conditions are tight and point to a slowdown. But broader measures, such as the indexes constructed by Goldman Sachs and the Chicago Fed, which factor in equity markets and corporate credit, show no significant tightening.
In fact, when adjusted for inflation, Goldman’s index remains easy and suggests the Fed should tighten even more than the market expects, according to a report by David Mericle, one of the bank’s economists. If so, that would be something to worry about.
Write to Randall W. Forsyth at [email protected]