The Yield Curve: An Imperfect Indicator in Evolving Market Conditions
The U.S. Treasury Yield Curve inverted recently for a few days, which provoked hand-wringing and doomsday predictions from all the usual market commentators in all the usual places.
So let’s examine this phenomenon, starting with the simple question:
What is an inverted yield curve anyway?
An inverted yield curve is simply the unusual case of short-term interest rates being higher than long term. Under normal circumstances, you wouldn’t lend money to anyone for a longer period at a lower rate– it just makes no sense. That’s why inverted curves don’t happen very often.
But all yield curves are not created equal. A perfectly inverted curve would have the 30-day (shortest) rate as the highest, with a consistently downward slope such that every year would be lower than the next and the 30-year rate would actually be the lowest yield of the curve. The current version (as of April 30, 2019) is a weird iteration, as it’s only inverted from 30 days to about 7 years, then it goes upward sloping again from 10 years to 30 years. So it’s only semi-inverted. We’ve plotted it here alongside the yield curve from May 31, 1989, which was the only “perfectly inverted” yield curve in modern history.
The ugly truth is that while the inverted curve has a better prediction record than any other macroeconomic indicator and we do take it seriously, I still don’t think it’s particularly valuable on its own.
Why is the Yield Curve Limited in Value?
Truth is, there just aren’t that many instances of inverted yield curves, so we don’t have nearly enough data points to generate any kind of statistical significance. Second, each yield curve inversion is so unique in circumstances that I don’t regard each data point as similar enough to group together. As an example, the past few times the curve inverted (the three most recent occurrences were in 2006, 2000, and 1989, shown above) the Fed took rates above the level of nominal GDP growth and whatever the NY Fed delineated as the “natural rate of interest.” Those preconditions are absent this time around.
Let’s also take a closer look at the bizarre past six months. The yield curve was NOT inverted in August when we started a dramatic and precipitous bear market that lasted until January 5th. Bond yields dropped really sharply in the 4th quarter, presaging the economic deceleration that we are seeing now.
But as yields have dropped and the prospects of more Fed rate hikes have disintegrated, the stock market flipped on a dime and had an epic 3 months since then. So while the economy has slowed and the curve moved towards inversion, the market has soared.
In essence, following the yield curve would have steered you in the wrong direction during the past six months of market volatility.
From many years of experience, my personal belief is that with so many more market actors making hair trigger decisions and trying to outguess everyone else, today’s stock market reacts much faster than in other eras to perceived economic changes and interest rate developments. This renders the “yield curve indicator” as just another signal which may not ultimately help us.
Most people view the “market” as a somewhat static entity that will react predictably to certain conditions. We at Bronfman Rothschild feel that this is misguided. To the extent that “the market” even exists as a unified entity, it is a changing and adapting organism in my experience. That doesn’t make the “market” right or wrong at any given moment about anything, but it sure makes it unpredictable.
So, to beat the dead horse, I am hesitant to ever make any broad conclusions about “the market” because I don’t even think it’s a 50/50 guess. For most, it could actually be less! Human beings just cannot wrap their arms around the futility of that, which is why we as a firm like to stress diversification, a long-term approach to investing, and skepticism of a belief in “timing” the market.