I have talked about this phenomenon before and must do it again today. All over the news recently is how the previously inverted yield curve is now no longer inverted.
Yield curve inversion is when short term Federal Funds Rate, set by the Federal Reserve, has a higher yield than longer term rates. The most common curve-inversion metric is the Fed Funds rate versus the 10-year Treasury bond. One can also make comparisons between the 30yr, 10yr, 5yr, 2yr and 1yr Treasury yields. Inversion is regarded as an indicator of a higher risk of recession in the near future.
The chart below shows, in blue, the spread between the US 10 year Treasury yield and the Fed Funds Rate. The orange is the Fed Funds rate, set by the Federal Reserve. Red is the 10-year Treasury.
We can see without a doubt that the past 3 recessions (grey bars) were preceded by a decline in the 10-year yield to BELOW the Fed Funds Rate. Longer term bonds carry higher rates of interest primarily due to inflation expectations. The natural state is to have the longest-term bonds pay more than shorter term bonds.
When the 10-year is below the Fed Funds rate, the curve is said to be inverted, as its expected longer-term rates are normally higher than short term rates (the Fed Funds rate is an overnight rate). The curve un-inverts when the 10-year yield goes back above the Fed Funds rate.
The financial media have spilled a lot of digital ink on this topic. When it first inverted, reports were based on a recession indicator. Now that it has normalized slightly, I’m seeing reports that the recession risk has passed.
The chart below clearly indicates that the past 3 recessions began as the curve un-inverted. Recessions are the grey vertical bars.
The process the last 3 times this has occurred was that; 1) market-driven yield on the 10-year bond went down, generally due to deteriorating economic conditions. 2) the 10-year gets below the Fed Funds rate (blue line under the 0% level), inversion. 3) The Fed begins to lower rates to stimulate the economy. It continues to lower rates basically until the recession is over (orange line). 4) The 10-year Treasury bond yield remains flat or vacillates some as the Fed lowers its Fed Funds rate below the Fed Funds rate, un-inverting.
The problem lays in that the Fed is doing the ‘un-inverting’, not market forces. Had the Fed left rates alone at 2.5% and the 10-year market-driven rate had gone up (due to increasing economic activity)—THAT would be healthy and a good sign for earnings and the economy.
It is important to remember that stock prices and the economy are only loosely tied together in the short term, stock prices can rise and remain elevated in the early stages of a recession. Also, it is possible that the curve inversion is falsely predicting a recession, however this indicator has a very high success rate.
Adam Waszkowski, CFA