The Federal Reserve Building in Washington:
No topic has dominated the investment conversation lately as much as the yield curve.
While it’s an arcane matter to most folks, we in the financial sphere have been thrown into a tizzy by this indicator of the economy’s future health—the graph of interest yields on bonds of increasing maturities, usually risk-free Treasury securities.
But some folks might be swinging at the wrong curve.
Typically, investors demand a higher yield for committing their money for a longer period, so the graph’s line rises from lower left to upper right, a positive slope in mathematical terms.
At times, such as now, yields at the shorter end of the market exceed those at the longer, creating an inverted yield curve. The most widely watched version of the curve focuses on the two-year Treasury note. At 2.44% midday Friday, its yield topped the benchmark 10-year note’s 2.38%. That reflects a marked change in market expectations of Federal Reserve policy.
In the past month, the central bank boosted its key federal-funds rate target for the first time since 2018 and signaled its intent to begin reversing the emergency monetary stimulus it began in March 2020 to counter the pandemic’s effects.
The yield on the two-year note—the Treasury coupon most acutely sensitive to shifts in Fed policy—jumped a huge 112 basis points in that time, according to Bloomberg. The 10-year yield rose by 65 basis points, also a considerable increase in a relatively short span. (A basis point is 1/100th of a percentage point.)
Historically, inversions of the two-to-10-year yield spread have been associated with recessions—five out of the past six, by one count. So is it time to go on recession watch?
No, given the booming labor market. The March employment data reported Friday showed nonfarm payrolls continuing to grow robustly, up 431,000 last month after an upwardly revised 750,000 increase in February. March’s jobless rate fell to a postpandemic low of 3.6%, from 3.8% the previous month, and for the right reason: strong growth in employment, which topped gains in labor-force participation, which hit a postpandemic high.
Recessions linked to the yield curve have been rooted in tight Fed monetary policies, which eventually tipped the economy into a downturn. Now, the curve’s moves are based on anticipated, rather than actual, Fed actions. The central bank only began its initial liftoff from the zero-percent floor last month. And it did so by a mere 25 basis points, to just 0.25%-0.50%.
The Fed (belatedly) is expected to get busier with hikes to rein in inflation running at a four-decade high. That has superseded its other mandate, full employment, which is mission accomplished, based on the jobs numbers. The fed-funds futures market is pricing in 50-basis-point hikes at the May and June policy meetings and 25-basis-point increases the rest of the year, for a December target of 2.50%-2.75%, according to the CME FedWatch site.
That is reflected in the sharp backup in the two-year yield curve. But the spread between three-month and 10-year Treasury yields is actually the measure to watch, according to the model developed by former New York Fed economist Arturo Estrella. And that curve remains distinctly positive and well out of recession-prediction territory.
In addition, while the 10-year yield is indeed up, it’s still low in absolute terms and deeply negative in real terms (that is, after inflation), writes Paul Ashworth, chief U.S. economist at Capital Economics, in a client note.
At the same time, 10-year TIPS (Treasury inflation-protected securities) trade at a real yield of minus 0.46%. Corporate and mortgage borrowing costs also are low and negative in real terms. And, Ashworth argues, even with the uptick in those rates, it’s unlikely that slowing growth in interest-sensitive sectors, such as housing, consumer durables, and business capital spending, “will do more than take a little gloss off of real economic growth.”
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 of lengthier maturities are set by the market, acting on rational expectations about the future.
As Jay Barry, head of J.P. Morgan’s U.S. government bond strategy, points out, the Fed has acquired more than 25% of the U.S. Treasury market through its quantitative-easing asset purchases. They have ballooned the central bank’s balance sheet to nearly $9 trillion, more than double its size at the beginning of March 2020. So the Fed’s outsize impact will continue, even as it begins to trim its holdings.
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The classic message sent by an inverted yield curve is that financial conditions are tight and portend a downturn. But broader measures, such as indexes constructed by Goldman Sachs and the Chicago Fed, which take equity and corporate credit markets into account, don’t show significant tightening.
In fact, adjusted for inflation, Goldman’s index remains easy and suggests that the Fed should tighten even more than the market expects, according to a report by David Mericle, one of the bank’s economists. If it did, that would be something to worry about.
Write to Randall W. Forsyth at firstname.lastname@example.org