Chicken Little and the US Yield Curve

07.19.2018 - Jeffrey S. MacDonald, CFA

"The yield curve is falling!"

Webster’s dictionary defines Chicken Little as “one who warns of or predicts calamity, especially without justification." In the original folk tale, Chicken Little gets hit on the head with an acorn and embarks on a journey to tell the king that the sky is falling and a catastrophe is coming. He collects several friends along the way, gets tricked by a fox, and either escapes or gets eaten by the fox, depending on which version you read.

Just an acorn, or a warning sign?

As a leading indicator of an impending catastrophe, at least of the economic sort, the shape of the US yield curve tends to have better predictive power than an acorn off the head. Many investors have become concerned that the flattening trend of the US yield curve is forecasting a recession in the near future. How likely, how soon and how severe a slowdown the current yield curve flattening is predicting are all concerns the market is currently wrestling with.

What is the “yield curve” and what historically drives its shape?

The yield curve in its simplest definition represents the difference in yield between bonds with varying maturities. When you connect these points with a line, the resulting “curve” can often times indicate investor views regarding certain types of risk.

In the case of economic growth, an “inversion” of the curve between 2-year and 10-year US Treasuries has been a pretty reliable forecaster of recessions for decades. Yields on these two points on the curve are generally driven by investor expectations for different market dynamics unfolding during different periods across an economic cycle. Yields on 2-year US Treasuries tend to be very sensitive to changes in Federal Reserve monetary policy, especially the future direction of the Fed Funds Rate. Investors in 10-year US Treasuries tend to be much more concerned with longer-term economic growth and expectations for future rates of inflation.

The shape of the yield curve is not static and can respond to multiple other factors like US Treasury issuance, central bank purchases, and investor appetite over the course of an economic cycle. While we acknowledge these influences, we believe the larger driver of today’s yield curve is the market’s current concern around “expectations” for future growth and Fed tightening. 

Why do investors fear the current flattening trend means a yield curve inversion is likely and that a recession is coming soon?

The yield curve is considered “inverted” when short-term yields exceed those of longer-term bonds. An inverted yield curve can be a powerful warning that there’s danger ahead—it has preceded every recession in the US for the past 60 years. Granted there is evidence of some false signals in past cycles but an inverted yield curve as an indicator of a future recession has been very reliable. In early July, the yield curve was flatter than it has been in a decade and the spread between 2-year and 10-year Treasury yields was just 32 basis points.

The current flattening trend has largely been driven by a rise in 2-year yields in response to the recent, and future expected, hikes in the Fed Funds Rate as the FOMC continues to normalize monetary policy. 10-year yields, while higher over the past 18 months, have remained somewhat stable against a backdrop of modest increases in wages and current inflation data. 

Inflation is also generally correlated with accelerations in economic growth and tight labor markets, which one could argue characterizes the current environment. This has encouraged the Fed to continue down the road of hiking rates, and with the Fed in tightening mode future policy and higher borrowing costs for the US economy could act as a brake on US GDP. This tightening of policy is a key component of the argument for recession. The concern being that the Fed over-tightens policy to the point where growth is stifled to the point of recession.

Why we think the fox probably goes hungry in this version of the story...

No doubt the fox had a feast on the US economy during the last “great” recession between 2007 and 2009. The US Treasury curve inverted, once again providing a reliable indicator of an upcoming recession. This recession was particularly severe and global in nature as an overindulgence in easy credit led to bubbles in housing and consumer debt that took years to recover from. 

We have to remember that inverted yield curves do not cause recessions. Yes, they can put some pressure on bank earnings, for instance, as lending and funding spreads get compressed, but the inversion of the yield curve is more of investor commentary on the outlook than a catalyst for a recession in US GDP.

Furthermore, we don’t currently see the types of excesses that characterized the lead-up to the global financial crisis (GFC). Housing markets are improving, though not overheating as before the GFC. Mortgage lending standards are, if anything, still tighter than average, reducing the chance we are headed for a leverage bubble for the consumer in housing. Equity prices are on the high side of fair by historical standards, but are not stretched to the point where we could consider them grossly overvalued where shares would be vulnerable to a market crash. The US economy continues to perform well and we believe that much of the impact of recent fiscal stimulus is still ahead of us. Remember all policy, both monetary and fiscal, works with a lag.

Let’s also not forget that the curve can invert long before a recession arrives. In the lead-up to the GFC the curve inverted in December of 2005, two years before the recession began, against an historical average of 19 months lead time between yield curve inversion and recession.

Yes, the economy is likely to slow at some point, maybe even to a mild or shallow recession. A reasonable target would be 2020 as the effect of the tax cuts and fiscal stimulus begins to fade. By then, the Fed will be closer to neutral and will have tools in the toolbox to add liquidity and stimulus to soften the downturn.

In our view, we are certainly closer to the end of the current growth cycle than the beginning, but corporate earnings continue to look supportive of stock prices and we believe the impact of fiscal stimulus is still ahead of us. We are not ready to hit the panic button yet, but we recognize that the cycle is evolving and volatility will be with us for the foreseeable future.

We agree there are plenty of acorns out there for the market to be concerned about. Non-real-estate borrowing for the consumer appears to be increasing (perhaps in response to a more optimistic outlook for the job market), corporations have taken on large amounts of debt in recent years, taking advantage of low yields and tight spreads and, most recently, global growth has come into question as tariff rhetoric has been on the rise among other risks.

These factors likely represent a drag on growth some years out. But when it comes to forecasting a downturn with the severity of the 2007-2009 crisis, we’re not ready to run and warn the king just yet.

This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of July 19, 2018 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. 
Historical performance does not guarantee future results and results may differ over future time periods. 

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