In normal times the interest rate on a bond with a long time to maturity would be higher than the rate on a bond with a short time to maturity. The additional yield on the longer maturity bond is compensation for tying your money up longer.
Therefore, the slope of the yield curve is normally referred to as positive with higher rates for successively longer maturities. The vast majority of the time (almost all of the time) the yield curve is positively sloped.
Today it is not, and that is a big concern.
Our recent experience with the abnormal yields began in early December when just a small part of the yield curve inverted. At that time there was a slightly lower yield on the five-year bond than on the three-year bond. I didn’t think it was anything to get too worried about and I expected when the stock market recovered it would return to normal.
Even though the stock market reached highs in April, it has not gotten better. As I am writing this, the yield on a 90-day T-bill is higher than the yield on the two-year, five-year and 10-year treasury bonds. Can you imagine that the yield you would get on a 10-year bond is about a tenth of a percent lower than you would get on a 90-day T-bill? That is definitely not normal and the fact that it has continued for more than six months is very concerning.
The primary reason an inverted yield curve is cause for concern is that each of the past seven recessions going back to the 1960s has been preceded by an inverted yield curve. The recession that followed those yield curve inversions didn’t happen right away. The amount of time from when the yield curve inverted until the recession began ranged from as little as seven months up to 19 months.
For this reason, many are predicting a recession will begin later this year or in 2020. It is important to note however that there have been a couple of instances where the yield curve inverted without a recession following.
There is no doubt that economic growth has slowed from the pace of last year. Several economic indicators, including industrial production and manufacturing, are much lower than they were last year. GDP growth in the second and third quarter of last year was 4.2% and 3.4% respectively.
Estimates for growth in the second quarter of this year are at 2.5%. The escalating trade war with China is likely having an impact on that.
There are a couple of important positives, though. The service side of the economy, while also down from the levels of last fall, continues to show good strength and the service sector accounts for nearly 80% of the U.S. economy.
Another big factor is the health of the consumer. From a spending perspective, roughly 70% of the U.S. economy is driven by consumer spending and the consumer is in very good shape. The jobs picture is the best it has been in more than 50 years.
On top of that, wage growth is the best it has been since the great recession. When the jobs picture and wage growth are strong, the consumer is strong. If the service side of the economy and the consumer are both healthy, it is difficult to foresee the economy slipping into a recession.
The Federal Reserve raised interest rates nine times in the last three-plus years, including four times last year. In January, Fed Chairman Jerome Powell indicated that the Fed was on hold from further increases in interest rates. Even though the Fed has been raising rates, the overall level of interest rates remains remarkably low. Both short-term and long-term interest rates are barely above the level of inflation.
It would be highly unusual for the Fed to switch from raising rates to lowering them when interest rates are near a zero real rate. Even so, the bond market is now pricing in an expectation of 2 interest rate cuts in the second half of this year. Could the Fed prolong this expansion with mid-cycle interest rate cuts? Possibly. It did just that twice in the mid-1990s. There are other examples of this in the 1960s, 1970s and 1980s.
The economic expansion began in June 2009 after the financial crisis. It now is the longest expansion in history. While this recovery has eclipsed the previous record holder of the 1990s, it has only produced about half as much actual economic growth as that 1990s expansion. The sluggish nature of this expansion has allowed it to go on without creating the excesses that tend to bring on the next recession.
Uncertainty is running high. Uncertainty about trade negotiations, interest rate policy and the health of the economic recovery. This is showing up in the yield curve ,and caution is warranted.
If a trade agreement is reached with China and the employment picture continues to be healthy, the economy would likely pick up. We could very well have another instance of a yield curve inversion that does not precede a recession.