The financial indicator is fabled but now fallibleby Paul Wallace / April 19, 2019 / Leave a comment
As prospects for the global economy darken the United States has remained a beacon of growth, helped by Donald Trump’s tax cuts. But a shadow is creeping over that light. The yield curve, a financial indicator with a reputation for predicting previous American recessions, is in the danger zone. Just how worried should we be?
The yield curve shows interest rates across the range of maturities—the periods over which money is borrowed—from short-term such as three months to long-term, typically ten years. The benchmark yield curve is for government debt (“Treasuries” in America) because it is the least risky. Typically it slopes upwards as the maturity of the Treasuries lengthens. Long rates are higher than short ones because investors generally demand a higher return for parking their money away for longer, exposing them among other things to the risk that it will melt away if inflation takes off.
But this “term premium,” or extra reward for long-term rather than short-term investing, does not hold at all times. And what economists have noted is that when the yield curve flattens and even inverts (so that short rates are higher than long ones, turning the term premium negative) that is an early warning of recession. Although the evidence for such a predictive property applies to the US, an American recession hurts economies around the world.
That’s why there’s anxiety now about the US where short rates are almost identical to 10-year rates. On Monday 15th April, rates on three-month Treasury bills were 2.43 per cent whereas yields on 10-year notes were 2.55 per cent. In late March the short rate was marginally higher than the long rate, inverting the yield curve.
On past form that indicates trouble ahead despite continuing evidence of momentum in the American economy, with a healthy increase in jobs of almost 200,000 in March. Although recoveries are not doomed to die of old age, another cause for disquiet is the sheer length of the recovery since the severe recession triggered by the financial crisis bottomed out in mid-2009. In July the upswing will become the longest ever on records stretching back to the mid-19th century.
Why should a flattening or even inverting yield curve spell trouble ahead? One reason is that it is picking up market expectations of a prospective about-turn in the direction of monetary policy. Starting in December 2015 America’s Federal Reserve has raised its key policy rate by 2.25 percentage points from the post-crisis low of between zero and 0.25 per cent. And since October 2017 the Fed has also been running down the assets it piled up through three bouts of quantitative easing—buying bonds by creating money—in the wake of the financial crisis.
The flattening yield curve is consistent with investors judging that the monetary squeeze has gone too far, requiring the Fed to switch to a looser stance. That expectation has already brought down long rates, which have fallen steeply since November, when they were above 3 per cent. This interpretation of the flattening yield curve chimes with the Fed’s change of course already this year to keeping its key rate on hold rather than pushing through more increases and also limiting the rundown of the assets it has purchased.
But there is another reason why long rates have declined. The markets are now anticipating lower inflation over the next decade than they did in 2018. That makes investing in long-term nominal debt more attractive and is incorporated in lower yields. The dampening in inflation expectations follows the surprisingly meek recent behaviour of inflation despite a tight labour market and a pick-up in wage growth. In January it was just 1.4 per cent according to the price index used by the Fed in relation to its 2 per cent target; the core rate, which excludes the more volatile categories of energy and food, stood at 1.8 per cent.
A reappraisal of the long-term outlook for inflation does not necessarily mean that the American economy is about to stumble into a recession. And there are other reasons to suspect that a flattening yield curve may on this occasion be giving a false signal. Most important is the continuing impact around the world of the extreme monetary policies adopted to prop up keeling economies following the financial crisis of 2008.
When central banks ran out of traditional ammunition after slashing short-term rates down to around zero they decided to act directly on long-term rates, by making big purchases of long-term securities. This quantitative easing aimed to reduce the term premium—and succeeded in doing so, with estimates suggesting it pared a full percentage point off ten-year Treasury yields in America. Much of that effect lingers since the Fed’s reduction of its balance sheet has been modest and achieved by allowing bonds to mature rather than selling them. Moreover, the Fed announced in March that the rundown of assets will finish this autumn, much sooner than seemed likely last year and leaving its balance sheet higher than previously expected.
In other economies, such as Britain and the euro area, central banks are still maintaining their stock of bought assets by reinvesting the proceeds of maturing bonds while setting interest rates that are much lower than in America. This matters because bond markets now operate internationally. Even though 10-year bond yields have fallen below 3 per cent in the US that is still attractive to investors in Germany and Japan where they are zero.
There is certainly good reason to worry about the global economic outlook as world trade growth dwindles, China’s growth sags and the eurozone flounders again. But it is too soon to man the lifeboats for the American economy, still less so on the basis of a single financial indicator. The yield curve may be fabled but it has become fallible.