On March 22, the 10-year Treasury yield fell below the three-month Treasury yield, an unusual occurrence called a yield curve inversion. The event occasioned scare stories by the media, with headlines such as “Yield curve inversion: recession sign sparks panic.” The market sold off a bit.
Here’s a chart showing the 10-year-minus-3-month yield spread going back to 1982 (the longest period available from FRED). When the line dips below the x-axis, the yield curve is inverted. The gray areas indicate recession.
Every U.S. recession in the past 50 or so years was preceded by a yield curve inversion by at most two years. However, the archetypal market cycle is about seven years, so having predictive power over a two-year horizon is not as prescient as it sounds.
Economist Campbell Harvey is credited with discovering the predictive power of yield curve inversions in his 1986 PhD dissertation. He found that the 5-year-minus-3-month spread predicted recession within two years if it was inverted for three months.
There isn’t just one official measure of yield curve inversions, but many. You can take the spread of any pair of Treasury maturities. The two most followed measures, however, are the 10-year-minus-2-year and 10-year-minus-3-month spreads. The 10-year-minus-2-year spread (the Fed’s preferred measure) is not inverted, so the two biggest indicators are conflicting right now.
A lot has been written on the yield curve inversion’s predictive power, but less on why. Once you look at the economic mechanisms behind yield curve inversions, the recent occurrence is far less portentous.
Let’s start with the basics. Treasuries are bonds issued by the Treasury department in maturities ranging from one month to 30 years. Because the U.S. government can print dollars, Treasuries are free of default risk. And because inflation has been kept under control for 30+ years by the Federal Reserve, markets treat Treasuries as if they now have little inflation risk, too. Most of the time investors demand higher yields for longer maturities, resulting in an upward sloping yield curve as shown in the chart below, which shows data from the beginning of 2014.
The Treasury yield curve is largely set by two forces:
The expected path of short-term Treasury yields, which is controlled by the Federal Reserve.
The term premium, the additional yield investors demand for running the risk that short-term interest rates don’t evolve in the expected manner.
In the past decade, the term premium has become much smaller and less volatile, so most changes to the yield curve mostly reflect changes to the market’s expectations of how Fed policy will evolve. This is especially true for short maturities.
In the chart below, I’ve added the yield curve as of March end.
It’s remarkably flat compared to the yield curve in the beginning of 2014.
Yield curve inversions are the result of a combination of two forces:
Bond investors expect the Fed to begin lowering short-term rates, almost always in response to slowing growth.
The term premium falls, usually in times of economic stress, as investors prefer the safety and certainty of longer-term Treasuries.
Economically, you’d expect most of the forecasting power of the yield curve inversion signal to come from the first factor, the expectation of easier Fed policy in response to slowing growth.
If you ignore the term premium, the current yield curve is telling us that that Fed is expected to cut short-term rates next year (by about 0.25% to 0.5%), which is normally a sign that the economy is slowing at a worrisome rate. Remarkably, it’s also forecasting that the Fed funds rate will average under 2.4% over the next 10 years, which is consistent with a deflationary, low-growth environment.
What is the yield curve telling us once you account for the term premium?
The term premium is not directly observable. It is estimated by subtracting investors’ expectations of the future path of Fed policy from the Treasury yield. Most models of the term premium agree that since the early 80s, when inflation and interest rates peaked, the term premium has gradually fallen and in recent years turned negative. (Why is beyond the scope of this post, but may be related to an aging population.)
The Federal Reserve Bank of New York publishes daily estimates of term premia according to a model developed by staff economists Tobias Adrian, Richard Crump, and Emanuel Moench (“ACM”). The ACM model estimates that the 10-year Treasury term premium is -0.8% as of March end. In other words, investors think short-term rates will average 3.2% over 10 years, but will buy a 10-year Treasury yielding 2.4% now to lock in that rate, according to this particular model.
The negative term premium has made it much easier for the yield curve to invert with small changes in the expected path of short-term interest rates. Indeed, the yield curve can now invert even when the expected path of short-term rates is positive, which was not true for most of the post-war era.
The chart below shows the Treasury yield curve minus the ACM term premia estimates as of the beginning of 2007 (around the time of the last yield curve inversion) and as of March end. The ACM model estimates that in 2007 the “pure” yield curve that reflects only the market’s expectations of Fed policy was indeed inverted. In contrast, the model says that today’s “pure” yield curve is not inverted—the market still expects a mildly upward sloping path for short-term interest rates.
Interestingly, the 10-year-minus-3-month spread went negative the day president Donald Trump announced he would nominate Stephen Moore to the Fed board. Moore is a Republican partisan. During the Obama years, he railed against the Fed’s easy monetary policy. After Trump slammed Fed chair Jerome Powell for hiking the Fed funds rate in December, Moore penned an op-ed, “Fire the Fed,” signaling to Trump that he would follow orders, practically begging for a spot on the Fed board.
Moore is likely to be confirmed by the Senate, and the Fed board will increasingly reflect Trump’s preference for easier monetary policy. The inversion of the yield curve, especially on the short end, may reflect this political reality more than it does growth fears. If this is the case, the recent yield curve inversion is ironically good news for stocks in the near term.