With the volatility seen in the last few weeks, bears and market pundits are scouring every data point released looking for signs of a recession. While our current economic expansion is at 106 months and counting, it doesn’t mean we are due for a recession. In fact, the Leading Economic Indicators Index from The Conference Board is still up more than 4% for the past six months.
Those bearish on the market continue to cite the recent flattening of the yield curve. The yield curve is a graphical representation of interest rates at a set point in time. Investors generally require a higher yield when their money is tied up for 10 or more years and expect a lower return on shorter maturities. During the week of April 16th, we saw a flattening of the yield curve, where the difference between the two-year Treasury and the 10-year Treasury was only 34 basis points, or 0.34%. Yet this past week, the 10-year Treasury surpassed 3% for the first time in several years, bringing the spread back to around 0.5%.
So, let’s take a closer look at interest rates. In general, the Federal Reserve has a lot of influence over short-term interest rates, as many of them are tied to the Federal Funds Rate, the rate at which banks lend on an overnight basis. The Federal Reserve has made it very clear they intend to continue raising rates throughout 2018, so the increase in short-term bonds should be no surprise.
Long-term interest rates are more indicative of investors’ inflationary expectations, the general concepts of where the economy is going, and long-term expectations for monetary policy. When the Fed raises rates, short-term bond rates tend to increase; however, that also means long-term bond rates could decrease, especially if the bond market believes the Fed is combating inflation. Inflation is the enemy of long-term bonds. If an investor expects 5% inflation for a long period of time, they are certainly not going to invest in a bond paying only 4%.
One of the reasons there has been so much angst over the yield curve is because it tends to invert before recession. We saw inversions before the recessions of 2000, 1991, and 1981. The yield curve also foreshadowed the beginning of the 2008-2009 recession. However, keep in mind the Federal reserve is also unwinding their $4.4 trillion balance sheet.
The unwinding of Quantitative Easing, or Quantitative Tightening, began in mid-2017 when the Fed discontinued the reinvestment of maturing bonds. This means someone else had to buy the bonds, often at a lower price with a higher yield. These actions should result in an increase in long-term interest rates, which will be good for investors who are investing their assets for principal protection to cover liquidity needs. However, we have never had a Federal Reserve with a balance sheet of a $4.4 trillion. This is unfamiliar territory for our Federal Reserve and economists alike.
Furthermore, the Fed has indicated that 2018 will see at least three rate hikes. While that sounds like a lot, in perspective, we should end this year with a Fed Funds Rate at 2% to 2.5%. By historical standards, that is still cheap credit.
While the yield curve may be moving more erratically than normal, the yield curve is only one of 10 leading economic indicators. The current yield curve hasn’t inverted, and we’re not near that point yet. Other signs are still favorable on economic growth.
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