What Is The Yield Curve Really Telling Us Today?
The yield curve is the difference between yields (current interest rates) on ten-year U.S. treasury bonds as compared to two-year treasury bonds. Last year the yield curve inverted, meaning the yield on the shorter-maturity two-year bonds is higher than that for the longer bonds. This is an unusual situation since longer bonds – which are riskier than shorter bonds – should normally pay more interest to compensate for the additional risk. As I wrote at the time (see https://www.cognizantwealth.com/2022/04/21/why-the-yield-curve-does-not-predict-a-market-downturn/) , the financial media and many market watchers asserted that such an event is the precursor to a recession and a subsequent stock market decline, because every recession since the 1970s was preceded by a yield curve inversion. The implication is to get out of the market until the curve normalizes.
What actually happened since the curve inverted over a year ago? No recession and a stock market that has increased by more than 10%.
I had originally maintained that there’s not enough data to be able to effectively utilize a yield curve inversion as a market timing mechanism. Not only that, the time between yield curve inversions and stock market declines has varied considerably, from 7 months to 22 months. Exiting the market at the point of inversion would have meant giving up double-digit returns in all but one occurrence (including last year).
Since the Fed has control over short-term rates but not long-term rates, a yield curve inversion is really nothing more than the outcome of a Fed-generated short-term interest rate increase – without a concomitant rise in long-term rates – typically for the purpose of controlling inflation. Cullen Roche at Discipline Funds goes further to suggest that an inversion should not be considered a recession predictor but rather a prediction that the Fed will reduce rates in the future because inflation is likely to be lower than it is presently.
Think about it this way: as of this writing the two-year treasury rate is 4.74%. That means the market is predicting that the Fed’s target rate over the next two years will average 4.74%. The current ten-year rate, 4.02%, means the market has a lower expectation of the Fed’s average rate looking farther out. That means the market expects inflation to be lower over the next ten years than it will be over the next two years, since the Fed would only reduce future rates if inflation were to come down.
If the Fed manages to control inflation at a level it deems satisfactory, without inducing a recession, it will have achieved what has been referred to in the media as a “soft landing.” And it will have been the first time a yield curve inversion was not accompanied by a recession. I’m hoping that’s the way it turns out, not only because it will benefit the economy and investors, but also in order to lay to rest what I consider to be a myth with respect to yield curve inversions.