Last May we wrote about inverted yield curves and concluded that even though they aren’t great indicators around the world, they have done a pretty good job of predicting recessions in the U.S. For those of you who don’t want to read old weeklies and don’t follow fixed income markets closely, the yield curve charts the interest rates that investors earn on bonds of differing maturities. Normally, long-term yields are higher than short-term yields, but when that relationship reverses and the yield curve inverts, bad things seem to happen to economic growth. The 2018 discussion was mostly academic because the yield curve, while flat, hadn’t inverted. Today, we no longer have that luxury: the three-month T-bill yield is higher than the 10-year rate. In fact, if you look at the U.S. Treasury yield curve you’ll see something unusual – it resembles the Nike symbol. A “Just Do It™” yield curve is a rare sight even for long-time fixed income traders. In past cycles both two-year and three-month yields were generally inverted concurrently. This time the two-year is pricing early interest rate cuts so its yield is lower than that of both the T-bill and the 10-year. The differences from past inversions don’t end there, and many analysts are saying that the unique characteristics of this cycle make the curve’s signals less reliable. Let’s look at these differences to see if the current environment has borrowed another Nike quote and redefined impossible.
Rates around the world are very low by historical standards. Both Japan and Germany have ten-year yields below zero. In comparison, U.S. 10-year yields at around 2% look like a quaint anachronism. As we all know, investors move their money around the world and are sometimes willing to take a little currency risk to get a few hundred extra basis points of interest. These fickle international investors may be bringing down the longer-term U.S. yields and artificially flattening the curve. The spread between German Bunds and U.S. Treasury bonds are at their widest since the days of Helmut Kohl, but spreads with Japan are well within the range they’ve held for over 20 years. 1 1 Close Japan has had very low yields for a long time, so the spread to U.S. Treasuries has been wide for many years. We think this effect is overstated, but looking into the reasons for low and negative yields brings up some of the more peculiar aspects of this cycle.
As we’ve talked about in the past, the phenomenon of lower yields around the world has baffled economists. They have been surprised at how interest rates can be so low without generating high nominal growth or inflation. We won’t go through all of their theories here, but as the progression of Fed forecasts has shown, the neutral interest rate has very likely fallen. 2 2 Close When the Fed began including its federal funds rate forecasts to its Summary of Economic Projections in 2012, its first median forecast for its longer run federal funds rate (often associated with the Fed’s forecast of the neutral rate) was 4.25%. The Fed’s forecast for its longer run federal funds rate has since fallen to a median forecast of 2.5% as of the Fed’s June 19, 2019 meeting. Source: Federal Reserve. In other words, the interest rate that is neither inflationary nor deflationary is considerably lower than it was in past cycles. Investors’ perception of the neutral rate greatly influences the yields they demand from long-term bonds and may be partially responsible for lower long-term yields. In addition, short-term rates at zero or lower may also be affecting the shape of the curve. Longer-term bonds may lose some of their premium as investors move into longer duration to get yield. 3 3 Close We used to say zero lower bound, but now people have become aware that zero is not the lower bound. Of course, we don’t know where, or even if, there is a lower bound so we use the vague “effective lower bound” terminology. These factors may have flattened the yield curve further than in past cycles.
These factors are both related to falling inflation. Inflation in the U.S. has been in secular decline since the early 1980s and many investors believe it is no longer the threat it once was. If you transported someone from 1981 and showed him or her the current price data, it would be a very pleasant shock. 4 4 Close That person could throw out his “Whip Inflation Now” button, but current events make his Ayatollah of Rock ‘n’ Rolla t-shirt still relevant. The flatter yield curve may represent a move away from investors demanding high compensation for inflation. 5 5 Close It may be that investors are demanding some protection for deflation, and less compensation for growth. You can see that in Breakevens and real rates derived from nominal Treasuries and TIPS. This is a topic big enough for at least two other Wrap-Ups. The inverted yield curve may just represent a change in investor preferences. It may really be different from past cycles.
Or it may not be. While the arguments for the demise of the yield curve seem convincing, they are not all that different from what we’ve heard in the past. Each time the yield curve has inverted, smart people have concocted reasons that it was no longer a valid signal. The last time it inverted in 2006, the Chair of the Fed said that a “global savings glut” was distorting long-term yields and that the yield curve was “not signaling a slowdown.” 6 6 Close The New York Times: “Language: Breaking the code of the Fed,” 4/23/06. Six years earlier the yield curve was inverted, but U.S. government was running large surpluses and cutting its issuance of Treasury bonds. 7 7 Close It’s almost impossible to imagine that that was ever the case, but it was less than 20 years ago. Some economists argued that the lack of bond supply was bringing down long-term yields and therefore the shape of the yield curve was no longer worth following. 8 8 Close The New York Times: “The Markets: Market Place; 2 U.S. Institutions Separated by an Uncommon Bond Policy,” 2/1/00. It’s a bit eerie, but if you go back a little further, the excuses sound even more familiar. In a 1989 article in The New York Times, several analysts are quoted as saying that the Fed’s success in bringing down inflation had brought long-term yields down and made yield curve inversion irrelevant. 9 9 Close You’ll see a familiar name in the article as well. Someone from the news earlier this year. , 10 10 Close The New York Times: “Credit Markets; Inverted Yield Pattern Persists,” 12/12/88. That could have been written yesterday.
In each of those supposedly unique episodes of yield curve inversion, the economy went into recession within two years. They were all different, but they were also the same. We have always argued that investors shouldn’t put too much weight on any single indicator. We know it’s easy to overestimate the predictive value of something only tested on a small sample, but we also know that it’s easy to find misleading distinctions from the past. We’re not going to forecast whether or not there will be a recession based on the yield curve. Instead, we’ll stick with our analysis from last year that the yield curve is probably still giving us at least some information about the economy. Not even a hundred articles on falling neutral rates or a Nike sponsored yield curve would change that. 11 11 Close The yield curve is not sponsored by Nike.
U.S. ISM Manufacturing PMI (Monday)
The ISM Manufacturing PMI has fallen significantly over the last few quarters, with last month’s reading the lowest since 2016. On balance, regional manufacturing surveys have pointed to further deterioration in June, and it is possible that the ISM falls below the psychologically important 50 level, which would indicate net negative responses from survey participants. While a sub-50 reading would not necessarily imply that the economy is in or near recession, it would be a strong piece of evidence that headwinds such as slower global growth and mounting trade uncertainties are impeding the U.S. expansion. Such a result would bolster the case for Federal Reserve easing, supporting domestic fixed income and perhaps weakening the U.S. dollar.
China Manufacturing PMIs (Monday)
Chinese economic data sent mixed signals around the Lunar New Year holiday, which often generates volatility in growth figures. However, the last couple of months have seen indicators such as industrial production, retail sales and the Manufacturing PMIs settle in at levels consistent with below-trend growth. The slowdown likely reflects similar factors to those weighing on the U.S. economy, although domestic efforts to bolster financial stability by reining in non-bank lending may also be having a lingering impact. Manufacturing PMIs for June will be watched closely to determine whether the May setback in trade negotiations between the U.S. and China led to a further stepdown in industrial activity.
U.S. Employment Report (Friday)
The U.S. labor market showed some signs of weakness in the latest data release for the month of May. Headline nonfarm payrolls disappointed to the downside and wage growth was weaker than expected. Weakness was fairly broad across industries, and was noteworthy as the survey period followed the disruption in trade negotiations between the U.S. and China in early May. While it’s too early to say whether this slowdown in job growth is the beginning of a trend, it increases the already-high importance of future job reports, as the Fed awaits incoming data to determine its next policy move. While a rapid slowdown in job growth would be concerning, the Fed is likely to view a slight moderation in payroll additions as a benign development because the economy is likely near full employment. Expectations for the June report are for job growth to remain slow compared to recent years, but to rebound from the May pace. Given this is the only employment report the Fed will receive before its next meeting, another downside surprise could push the Fed in a more dovish direction.