Is The Yield Curve Bearish For Stocks?

Fig. 3 ). Do a Google Trends search on “yield curve” for the past five years, and you’ll see a trendless series through the end of last year, followed by an upward-trending series so far this year with a spike in June.

The Federal Open Market Committee (FOMC), the entity that sets the Federal Reserve’s monetary policy, raised the federal funds rate by 25 basis points (bps) on June 13 to a range of 1.75%-2.00%, following a similarly sized hike on March 21 (Fig. 5 ).

A higher short end of the yield curve than long end suggests that investors expect interest rates to decline, which usually happens just before recessions. Is the yield curve about to invert? If it does, will that mark the eighth time in a row that this indicator accurately predicted a recession and a bear market in stocks?

It’s hard to argue with success. It’s always unsettling when arguments are made for why “this time is different.” Nevertheless, let’s go there. Consider the following:

(1) One of 10. In my new book Fig. 6 ). So the LEI certainly isn’t sounding a recession alarm.

(2) Credit crunches. In the past, the Fed would raise the federal funds rate during economic booms to stop an acceleration of inflation. Fed officials did so aggressively, perhaps in no small measure to shore up their credibility as inflation fighters. Tightening credit market conditions often triggered a credit crunch—particularly during the 1960s and 1970s, when interest-rate ceilings on bank deposits were set by Regulation Q—as even the credit-worthiest of borrowers found that bankers were less willing and able to lend them money (Fig. 7 ).

Sensing this mounting stress in the credit markets and expecting the credit crunch to cause a recession and a bear market in stocks, investors would pile into Treasury bonds (Fig. 8 ). The yield curve inverted, accurately anticipating the increasingly obvious chain of events that ensued—i.e., rising interest rates triggered a credit crisis, which led to a widespread credit crunch and a recession, causing the Fed to lower short-term interest rates.

(3) No boom, no bust. So how can we explain the flattening of the yield curve during the current business cycle? Inflation remains relatively subdued, having risen to the Fed’s 2.0% target (measured by the personal consumption expenditures deflator excluding food and energy on a year-over-year basis) during May—for the first time since the target was explicitly established by the Fed on January 25, 2012 (Fig. 9 )!

The Fed has gradually been raising the federal funds rate since late 2015, yet few critics charge that the Fed is behind the curve on inflation and needs to raise interest rates more aggressively. The economy is performing well, but there are few signs of an inflationary boom or major speculative excesses that require a more forceful normalization of monetary policy.

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(4) Globalized bond market. In my opinion, the flattening of the US yield curve is mostly attributable to the negative interest policies of the European Central Bank (ECB) and the Bank of Japan (BOJ) (Fig. 11 ).

Such yields certainty make comparable US Treasury bonds very attractive to investors—especially when the dollar is strengthening, as has been the case this year (Fig. 12 ). When investors turn defensive and want to park their money in a safe asset, the US Treasury bond clearly offers a more attractive return than bunds and JGBs.

(5) Bond Vigilantes. In other words, the US bond market has become more globalized, and is no longer driven exclusively by the US business cycle and Fed policies. In my book, I discuss the close correlation between the 10-year Treasury bond yield and the growth rate of nominal GDP, on a year-over-year basis (Fig. 14 ). The former has always traded in the same neighborhood as the latter. I call this relationship the “Bond Vigilantes Model.” The challenge is to explain why the two variables aren’t identical at any point in time or for a period of time. Nominal GDP rose 4.7% during the first quarter of 2018 and is likely to be around 5.0% during the second quarter, on a year-over-year basis. Yet the US bond yield is below 3.00%.

During the 1960s and 1970s, bond investors weren’t very vigilant about inflation and consistently purchased bonds at yields below the nominal GDP growth rate. They suffered significant losses. During the 1980s and 1990s, they turned into inflation-fighting Bond Vigilantes, keeping bond yields above nominal GDP growth. Since the Great Recession of 2008, the Wild Bunch has been held in check by the major central banks, which have had near-zero interest-rate policies and massive quantitative easing programs that have swelled their balance sheets with bonds. Meanwhile, powerful structural forces have kept a lid on inflation—all the more reason for the Bond Vigilantes to have relaxed their guard.

As noted above, a global perspective certainly helps to explain why the US bond yield is well below nominal GDP growth. So this time may be different than in the past for the bond market, which has become more globalized and influenced by the monetary policies not only of the Fed but also of the other major central banks.

(6) Another Fed Model. The latest Fig. 15 ).

The note’s authors stress that the long-term spread reflects the near-term spread, which they argue makes more sense as an indicator of a recession that is expected to occur within the next few quarters. They also observe that an inversion of either yield spread does not mean that the spread causes recessions.

Their current assessment is that “the market is putting fairly low odds on a rate cut over the next four quarters,” i.e., 14.1% (Fig. 16 ). “Unlike far-term yield spreads, the near-term forward spread has not been trending down in recent years, and survey-based measures of longer-term expectations for short term interest rates show no sign of an expected inversion.”

What a relief! So now, all we have to worry about is a recession caused by a trade war!

Written By: Ed Yardeni