The True Signal From Inverted Yield Curves

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Q2 hedge fund letters, conference, scoops etc

This article originally appeared on ETF.COM here.

As is almost always the case, investors have plenty to worry about. If concerns about a trade war weren’t enough, the financial media has been filled with talk surrounding the risks presented by the flattening of the yield curve.

Adding to those concerns is that the Federal Reserve has begun to reduce liquidity by unwinding its massive balance sheet.

Articles highlighting these issues have led to a lot of questions from investors and advisors who have become concerned about the possibility, if not the likelihood, of the Treasury yield curve actually inverting. The reason for the concern is that the slope of the yield curve historically has been a good recession predictor.

What inverted yield curve signals

Specifically, when the curve is inverted – that is, the yield on three-month Treasury bills is greater than the yield on the 10-year Treasury note – a recession is likely in the near term.

Similar signals can be observed if the two-year Treasury note replaces the three-month Treasury bill. In other words, the signal is robust to various definitions, providing confidence that it is not likely to be a random outcome or the result of a data-mining exercise.

You can see evidence of this in the following chart, which depicts the most recent recessions (in gray) plotted against the yield spread between two-year Treasury notes and 10-year Treasury notes.

Inverted yield curve

Fed pushing rates higher

The concerns about an inverted curve arose because the Fed has continued to push the federal funds rate upward. Its current target rate is now 1.75-2%, and that has pushed the three-month Treasury bill rate to 2%. With the current 10-year Treasury note rate at 2.89% as I write this on July 20, that means there is still a gap of almost 1 percentage point before the curve would invert.

It’s certainly possible, if not highly likely, that if the Fed continues to raise rates this year (it has signaled the market that it expects to continue to gradually increase rates, and the market now expects one to two more 25-basis-point increases, pushing the federal funds rate up to 2.25-2.5%), all yields could rise, not just the yields on the short end of the curve.

Thus, we are still quite a ways from the curve inverting, at least based on the traditional measure of the three-month Treasury bill to 10-year Treasury note spread. So, why is the market so concerned?

Predictive signals before

The main reason is that, as I previously noted, the inversion signal has worked pretty well when using the two-year Treasury note to 10-year Treasury note spread. As I write this, with the two-year Treasury note yielding 2.59% and the 10-year Treasury note yielding 2.89%, that spread is just 0.30%. That is down from about 1.25 percentage points when the Fed began its rate-hike cycle in December 2015. That makes an inversion more likely than when we looked at the spread using three-month Treasury bills.

Those investors tuning in regularly to cable financial news are hearing persistently about that two-year Treasury note to 10-year Treasury note spread. (Note: The financial media in general needs you to worry or you wouldn’t feel the need to “tune in” all the time.) With that in mind, I thought it would be helpful to provide some perspective, which might help investors avoid hitting that panic button.

Read the full article here by Larry Swedroe, Advisor Perspectives

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