- When short-term bond yields surpass long-term rates, trouble for the economy often follows.
- Investment decisions should not be driven by a single economic indicator.
- A broad set of leading economic and market indicators suggests it may be premature to deviate from a sound, long-term investment approach.
Several months back, Mrs. Commentator suggested I try yoga (which I prefer to call stretching) for relief from my chronic lower-back pain. While I was skeptical at first, after a few weeks I noticed considerable improvement. Especially helpful: inverted poses stretches, such as the so-called Downward-Facing Dog (shown below).
Like the pain in my back, interest rates have also been topsy-turvy of late. Yields on some shorter-term Treasuries have risen above longer-term counterparts.
Under normal market conditions, bond investors demand higher yields from long-term bonds relative to short-term bonds because, all else being equal, there’s more risk lurking over longer stretches of time. A bond holder with a relatively lengthy time horizon must wait longer to be repaid and longer means more possibilities of adverse changes in market conditions that negatively impact bond prices — increases in interest rates and higher inflation, for instance. Compensation for bearing that extra risk typically arrives in the form of higher yields. But sometimes the market misprices this risk with an inverted yield curve.
To understand how this mispricing works, consider a graphical illustration. The chart below shows a normal curve: interest rates paid on bonds (with the same credit quality) rise as maturity lengthens.
The yield curve is said to be “inverted” when rates on longer-term bonds (such as the 10-year Treasury Note) are below the yield on shorter-term instruments (2-year Treasuries, for instance). An inverted yield curve may look like this:
Inverted Yield Curve
The reason the shape of the yield curve is widely followed is because an inverted yield has often been an early warning of economic recession. For example, the chart below shows that the rate on 2-year Treasury Notes rose above the rate paid on 10-year Treasuries before each of the last five recessions (which are shaded in gray).
Why does the yield curve tend to invert ahead of economic contraction? Perhaps the leading catalyst is the central bank. The Federal Reserve has a habit of raising short-term interest rates a bit too much. Sensing trouble ahead, investors are inclined to seek safety as well as look for ways to profit from an upcoming recession. In turn, the market tends to bid up the prices of longer-term bonds, which pushes longer-term bond rates down.
However, by many measures America’s economy seems quite healthy at the moment.
- The U.S. grew at a robust 3.1% in the first three months of the year.
- The U.S. labor market is the strongest it’s been in decades.
- On a year-over-year basis, retail sales are up 3.1% and non-store retail sales have grown by 9%.
- The Conference Board’s Consumer Confidence Index is near a record high.
It’s also important to recognize that an inverted yield curve does not provide insight on how severe a recession will be. Additionally, if a recession does follow an inverted curve, it can take as long as 24 months to start. Moreover, the curve’s inversion often ends before a recession begins.
Keep in mind that while the yield curve’s track record on forecasting recessions is impressive, the yield spread should not be regarded as a flawless forecasting tool. And while some sections of the curve are inverted, some widely followed maturity combinations are still positive. Notably, the spread is negative at the moment for the 10-year and 3-month yields, but the 10-year and 2-year gap remains positive, albeit just barely.
Given the foregoing, altering your investment portfolio in response to the shape of the yield curve, or any other single indicator, seems misguided. Accordingly, The Milwaukee Company has developed The Milwaukee Company’s Economic Index (MCEI) to identify the current state of the economic cycle. MCEI uses a combined reading of the Chicago Fed National Activity Index’s (“CFNAI”) three-month moving average and a probit model of numerous economic indicators to determine if the economy is expanding, contracting, or somewhere in between. Based on the latest numbers, output is still growing. For details, you can find MCEI’s latest reading here.
In addition, The Milwaukee Company has developed The Milwaukee Company Hedge Index (MCHI) to forecast the expected risk of the U.S. stock market in the near term (roughly one month forward). MCHI also uses a probit model similar to that of MCEI, but analyzes a set of market and economic indicators (as opposed to MCEI, which uses just economic indicators) to estimate if the U.S. stock market is facing a high or low probability of a bear market (i.e. recession). MCHI is currently forecasting a low risk of a bear market.
Of course, all forecasts are based on historical data and so we can never rule out the possibility of surprises. The future, in short, is uncertain. However, a thorough consideration of leading economic and market indicators suggests that this is not the time to abandon a solid, long-term investment plan.
Thank you for reading,
Mr. Market Commentator