Published on Apr. 10, 2019
Don’t Fear the Curve
Within the community of market analysts, it is well understood that an economic slowdown (and even a recession) can be signaled by an inverted yield curve, with about a year’s lead time, because the inversion in the curve can signal that interest rates in the future may be expected to be lower than rates today. “Inversion” refers to the fact that the yield on short-term notes exceeds that on longer notes.
At this writing, the yield on three-month Treasury Bills exceeds the yield on three-year Treasuries, which have the lowest yield on the U. S. Treasury curve. Do we freak out?
Probably not! We believe that the future isn’t always like the past and, after a decade of near-zero rate monetary policy, perhaps the recession-signaling value of the inverted yield curve needs further examination.
Our working hypothesis is that lower long-term rates have less to do with an economic slowdown and more to do with low inflation expectations and limited economic volatility. Yes, in the past four years the Fed implemented nine rate increases in the Federal funds target rate of 25 basis points each. It did this initially to lift the rate out of the post-’08 extreme accommodation approach, because monetary policy generally operates with a lag, to dampen an economy as employment started to soar. The expectation was that wage pressures would not be far behind employment growth. The Fed may have hoped to be able to ease inflation expectations in an attempt to control inflationary pressures. We think that the acceleration in employment is a big story. We believe that the labor market is solid, which should continue to provide for contributions to consumption, an important driver of economic activity.
The accelerating inflation story hasn’t played out, or hasn’t played out yet, as inflation has been lower than expected. We chalk this up to technology, demographics, and globalization because together they have held down costs and pricing power. We believe that for the Fed, the dilemma is that the economy is growing and unemployment has dropped, yet inflation hasn’t accelerated. It’s a good problem to have if you fear inflation, but the Fed may have expected more inflation at this point in time. Because of this it appears that on the surface, we have restrictive monetary policy and that is why we think calls are now being made by pundits for the Fed to lower rates.
We believe that the bond market is signaling a healthy economic environment. Credit markets had a strong first quarter, and to us the tightening of credit spreads is indicative of healthy balance sheets and firms meeting their financial goals. For us, this translates into what we believe may be a continued period of steady economic growth and returns for investment grade credit securities. If credit spreads were to widen, that would be a concern for us.