April 02, 2019
Do Inverted Yield Curves Always Signal a Recession?
Lawry Knopp, VP-Funding & Hedging
U.S. Treasury long-term yields have moved lower in recent days following the March 20 update on monetary policy by the Federal Open Market Committee. In addition, global growth metrics are signaling weakness and markets are trading in risk-off mode. In its policy statement, the FOMC indicated its intention to keep interest rates unchanged for the rest of 2019 and to end balance sheet reductions by September. The potential for a rate hike in 2020 remains. This marked a significant shift to a more accommodative stance compared to the December and January statements when multiple rate hikes and continued balance sheet normalization remained on the table.
Both the 2-year and 10-year Treasury securities are trading near the low end of their respective 1-year trading ranges. The 2-year is yielding 2.32 percent in a trading range of 2.20 to 2.97 percent. Similarly, the 10-year yield is at 2.49 percent in a 1-year trading range of 2.37 to 3.24 percent. Other factors adding downward pressure on Treasury yields include risk-off trading as investors remain concerned over the prospect of a global slowdown, a messy Brexit and ongoing trade tensions between the U.S. and China.
In the past, we’ve talked about yield curve inversions, which are the result of short-term interest rates being higher than long-term interest rates. When this phenomenon occurs, a recession typically follows within a year or so. Last week, the 3-month Treasury was trading at a higher yield than the 10-year, which resulted in a negative spread between the two term points.
Yield curve inversions are usually due to a difference of opinion on the part of the Federal Reserve – specifically, the Federal Open Market Committee – and investors and traders, generically referred to as the market. With longer-term interest rates being low, the market is saying it believes the economy is losing momentum and inflation is slowing. On the other hand, Federal Reserve officials have acknowledged some loss in momentum, but believe the economy is in decent shape with inflation remaining near its desired target and see no need to ease policy rates at this time.
There are various models that calculate the probability of the economy going into recession within the next 12 months based on the spread between short-term and long-term rates. The New York Federal Reserve version, as of early March, shows a probability of 24.6 percent, which is close to levels that preceded past recessions. The model goes back to January 1959.
The historical record indicates the yield curve has a strong track record for predicting recessions, but each time it happens opinions vary about whether “this time is different.” I agree, this time is different; each time the curve inverts, the circumstances are different. Compared to previous inversions, the current nominal level of interest rates is much lower and the amount of stimulus in the monetary system is much higher. On a global basis, we have over $10 trillion in government debt at a negative yield, investments held by the major central banks exceed $18 trillion (up from $5 trillion in 2008), and the European Central Bank’s short-term policy rate is at negative 0.40 percent while the Bank of Japan’s short-term policy rate is negative 0.10 percent. Despite the extreme policy measures currently in effect, growth remains sluggish and makes me wonder if monetary policy is losing some of its effectiveness as economies contend with extremely high levels of debt and debt-service demands, fiscal policy largesse and a restrictive regulatory environment. In some cases, it appears central banks are “pushing on a string.”
A quick review of the fundamentals (growth, inflation and employment) indicates the economy is continuing to expand, albeit at a slower pace. Gross Domestic Product grew by 2.2 percent during Q4-2018, which was weaker than the 3.4 percent growth rate for Q3-2018. Economic activity slowed on weaker consumer spending as equity market volatility, trade worries, winter weather and political squabbling in Washington, D.C., negatively impacted sentiment. Housing continues to struggle as higher mortgage interest rates reduce affordability and the number of homes for sale remains low. Despite weaker growth in Q4, the year-over-year growth rate for 2018 was 3.0 percent.
First quarter 2019 growth is expected to expand by 1.0 to 1.5 percent, with the remainder of 2019 expected to average 2.0 to 2.5 percent growth. All-in-all, this is not robust growth, but is adequate to maintain employment near current levels. We are seeing weekly claims for jobless benefits hover around 220,000, which signals stable employment ahead. Look for the unemployment rate to be between 3.7 to 4.2 percent for 2019 as household employment is able to match the growth in the labor force. Monthly non-farm payrolls are expected to continue expanding by 150,000 to 200,000.
Assumptions for inflation indicate modest increases in consumer prices for the rest of 2019 as increases in labor, energy and housing costs are moderate. The consumer price index will likely increase by 2.25 to 2.50 percent for 2019. The core rate of inflation, which excludes food and energy prices, is expected to show similar readings. Core personal consumption expenditures, the Fed’s preferred inflation metric, is projected to be around 2.0 percent for 2019.
Elsewhere, the dollar is holding on to recent gains despite the shift in monetary policy. Meanwhile, oil prices are relatively stable, notwithstanding efforts by OPEC and other major oil export-based nations’ efforts to trim production and push prices higher. The trading range for WTI crude is $44 to $76 per barrel, with the current price indicated at $61.60.
After a difficult second half of 2018 for the eurozone and Asian economies, recent surveys on manufacturing and services for China indicate the potential for stronger growth for the Asian economies. This may benefit the euro-region somewhat, but weaker growth may linger for a while longer as the United Kingdom’s Parliament remains deadlocked on passing a deal for Brexit. Italian deficit spending levels and excessive debt levels in its banking system remain contentious issues for the European Union. Fragmentation among member countries and European Parliament elections scheduled for May could change the political landscape in the region.
View on Interest Rates
The Federal Reserve has indicated its intention to be “patient” in assessing monetary policy and to adjust rates as necessary and end quantitative tightening by September. Nevertheless, the Federal Open Market Committee is still considering a rate hike in 2020. Based on Federal funds futures, the market is currently indicating no chance of a rate hike this year and more than a 60 percent probability of a rate cut at the December 2019 or January 2020 FOMC meeting.
Until the two opposing views on the outlook for the economy by the Fed and the market consolidate, look for Treasury yields to remain near current levels with periods of elevated volatility. A resolution to trade issues between the U.S. and China could significantly improve the global economic outlook and bring the perspective of Federal Reserve policymakers and the market much closer together.
The above commentary is a summary of select economic conditions prepared for Northwest FCS management. It is being shared as a courtesy. As with any economic analysis, it is based upon assumptions, personal views and experiences of those who provided the source material as well as those who prepared this summary. These assumptions, conclusions and opinions may prove to be incomplete or incorrect. Economic conditions may also change at any time based on unforeseeable events. Northwest FCS assumes no liability for the accuracy or completeness of the summary or of any of the source material upon which it is based. Northwest FCS does not undertake any obligation to update or correct any statement it makes in the above summary. Any person reading this summary is responsible to do appropriate due diligence without reliance on Northwest FCS. No commitment to lend or provide any financial service, express or implied, is made by posting this information.