Last month the yield on the 10-year Treasury bond fell below that of the 2-year Treasury bond, reflecting a further inversion of the yield curve. While this inversion certainly added to investors’ anxiety, it is not a new development. In fact, portions of the yield curve have been inverted since last December—meaning that shorter-term rates have been higher than longer-term rates.
WHAT IT MEANS
Ordinarily, an inverted yield curve may reflect that markets expect an economic slowdown or recession (and thus lower future interest rates). This signal may be followed by a credit creation decline as financial institutions become less incentivized to provide loans. Banks experience declining profitability as they pay out more on short-term deposits and receive less revenue from making long-term loans. A slowdown in credit creation ultimately inhibits economic growth, which in turn, contributes to a recession.
DIFFERENT THIS TIME?
Given the extent to which the Federal Reserve has influenced the short-end of the yield curve, some economists contend that the traditional implications of an inverted yield curve may be less clear than in the past. The Fed’s quantitative easing program has muddied the water and made it unclear how much recession risk is truly being forecasted by the inverted yield curve.
In April JPMorgan CEO, Jamie Dimon, noted in an annual letter to investors that he “would not look at the yield curve and its potential inversion as giving the same signals as in the past… There has simply been too much interference in the global markets by central banks and regulators to understand its full effect on the yield curve.”
IS A RECESSION IMMINENT?
Per Bloomberg surveys, economists have raised the probability of a U.S. recession within the next 12 months, though still projecting relatively healthy U.S. economic growth due to strong consumer spending and a robust labor market. That said, it is worth noting that economists historically have a dismal track record of predicting recessions.
Since 1955 there have been nine recessions, each preceded by an inverted yield curve (defined as the yield on the 1-Year Treasury rising above the 10-Year Treasury). There was, however, one period (1967) when an inverted yield curve did not precipitate a near-term recession.
Historically the lag time between a curve inversion and the ensuing recession has ranged from one month to several years—making this “recession signal” less useful than it first appears.
At this time, we believe it would be ill-advised to make a portfolio allocation change based on the inverted yield curve. We are in uncharted waters with the past ten years of quantitative easing by the Fed, and it is currently unclear how this will impact the “recession signal” given by the inverted yield curve. Even if the inverted curve is signaling an upcoming recession, no one knows if it is weeks, months, or years in the future.
The good news for JOYN clients is that our portfolio construction process strives to make us well prepared to navigate the next recession whenever it may occur.