December 31, 2017
Over the last several months an indicator that has historically been accurate in signaling a pending economic slowdown/recession has been flashing yellow. We are talking about the yield curve, and specifically the spread between the 2 year Treasury at the short end of the maturity curve and the 10 year Treasury in the middle. An upward sloping yield curve, one where longer dated maturity bonds have higher yields than shorter maturity issues, is generally believed to indicate a growing economy with normal levels of inflation. A flat or inverted yield curve can indicate investors are worried about macroeconomic forces like slowing growth or falling inflation. Those of bearish persuasion are quick to point out that the yield curve has flattened and subsequently inverted prior to each of our last three recessions. This cycle, the 10/2 year Treasury spread has been positive, ranging from roughly 150 to 280 basis points for most of the first four years of the economic recovery that began in 2009. Over the course of 2016 and 2017, however, the spread began to narrow and now sits at just approximately 51 bps (see chart). If the curve were to continue to flatten/invert in the coming months and economic history repeat, we might expect a recession to ensue.
Here are a few reasons, though not necessarily an exhaustive list, why we believe this historically reliable indicator may be somewhat less so at this particular time:
- With the Fed having commenced a Fed Funds tightening cycle, most recently raising their benchmark interest rate to 1.5% in mid-December, yields on the short end of the curve have been moving higher in lockstep. That said, Quantitative Easing on the part of The Federal Reserve, European Central Bank and Bank of Japan (among others) has at least in part resulted in artificially lower yields further out the curve. Persistently low inflation has also kept long-dated maturity yields low. Though the Fed has begun to unwind its balance sheet, ongoing QE programs in Europe and Japan may continue to serve as an anchor for US yields, as will generally moderate levels of inflation that are expected to persist. For now, these factors may result in a flatter yield curve while not necessarily signaling coming economic weakness.
- Cyclical sectors of the economy still are not operating at excessive levels. Though we are now nine years into economic expansion, this recovery has been more moderate than usual. As such, sectors of the economy like housing, auto production and factory utilization all have further room to improve from current levels before they would begin to look stretched and be at risk of moderating.
- The US and global economy are gathering momentum, not losing it. After a weak start to the year, real GDP increased only 1.2% in the first quarter of 2017, U.S. economic growth improved and looks to have increased close to 2.5% for the year as a whole. The second and third quarters of the year showed gains of 3.1% and 3.2% respectively and the fourth quarter probably increased 2.5-3.0%. The global economy has also improved, with the International Monetary Fund and other economic forecasters raising their projections throughout the year.
- Recent passage of tax reform should provide further fuel for growth. Corporate profits get a boost from lower corporate tax rates (individuals could also see a benefit) and the passage of the legislation ought to further improve already elevated levels of investor, business and consumer confidence. Even though the economy is mature in terms of duration, we believe another year of around 2.5% real GDP growth is possible in 2018 as job gains remain healthy, confidence is high and financial conditions are easy.
As most know, the phrase “this time is different” is always dangerous when applied to the financial markets. More often, the saying attributed to Mark Twain that history may not repeat but will frequently rhyme is usually a safer assumption. As such, we will continue to be mindful of this indicator rather than be outright dismissive of it. It is also important to note that recession did not immediately commence these prior three periods as soon as the spread went negative. In each case it was 12 to 18 months later that the economy officially went into recession, giving investors ample time to monitor incoming economic data and make portfolio adjustments as desired.