OR HAS IT LOST ITS MOJO IN 2019? …
There has been a lot of news lately about the so-called inverted yield curve and its reputation for predicting recent recessions, so we thought our followers might appreciate a brief tutorial on bond yields and our assessment of their economic forecasting value in 2019.
The bond yield curve is the difference between yields on long-term (e.g., 10-years) and short-term (e.g., 3-months to 2-years) Treasuries; fixed-income securities sold by the U.S. Treasury.
Bond yields move inverse to prices, and are a function of the economic forecast, interest rates and investor demand, as reflected in the bond curve dynamics table below.
If bond buyers are bullish on the economy and believe interest rates will be rising, they prefer to hold short-term bonds in order to capture higher yields later. That higher demand for short-term bonds causes their prices to go up and yields to go down. The reverse is true for long-term bonds. Generally, yields on long-term bonds are higher during economic expansions because bond buyers need more compensation to be locked in for longer periods of time.
If bond buyers are bearish on the economy and believe interest rates will be lowering, they prefer to hold long-term bonds in order to lock in the current higher yields. That higher demand for long-term bonds causes their prices to go up and yields to go down. The reverse is true for short-term bonds.
When economic sentiment gets too bearish, long-term bond yields can actually fall below short-term yields, which is called a yield curve inversion. Historically, inversions have been viewed as a reliable indicator of a forthcoming recession.
Experts are split on which inverted yield curve is the most reliable predictor. Some prefer looking at the spread between 10-year and 2-year Treasuries, like the graph below. (Red arrows indicate negative spreads or yield curve inversions preceding U.S. recessions in shaded areas.)
The Federal Reserve prefers looking at the spread between 10-year and 3-month Treasuries. On Friday, March 22, this spread turned negative (i.e., inverted) for the first time in nearly a decade, to minus 0.196 percentage points.
Does the recent yield curve inversion event portend a recession? FH presents two outlooks …
THE SKY IS SORT OF FALLING OUTLOOK
The combination of slowing global growth (40% of S&P 500 corporate profits come from international operations), trade disagreements, and a U.S. yield curve inversion might very well portend a forthcoming recession. However, recent recessions haven’t happened immediately after inversions. They typically occur one to two years afterwards, and the stock market usually continues to gain from the day of the inversion until its cycle peak. So even though a recession appears likely, you still have time to prepare and profit.
THE SKY IS NOT FALLING OUTLOOK
Extremely low and even negative global interest rates (Germany and Japan) plus astronomical levels of quantitative easing have distorted demand for U.S. long-term treasuries, thereby creating extraordinary and unique bond yield circumstances not indicative of a forthcoming recession. Additionally, U.S. economic growth is solid, led primarily by consumer demand, which should not abate given rising confidence, employment and wages. Lastly, assuming successful negotiation and implementation of USMC, Korean, Japan and China trade deals, along with increased business investment, the U.S. will likely lead the world out of its current economic slump. Then long-term bond yields will rise and we will once again be on the proper side of the yield curve.