Vanguard: The Yield Curve Inversion And What It Means For InvestorsAdvisor Perspectives
The U.S. economy has seen a prolonged period of growth without a recession. As the business cycle has matured, the U.S. yield curve has flattened substantially. We expect further flattening and an increasing likelihood of curve inversion as the Federal Reserve continues to raise interest rates.
Historically, an inverted yield curve has been a strong leading indicator of an economic slowdown. There has been a growing debate, however, on the relevance of this signal in an environment where the bond market has been distorted by quantitative easing (QE). We find that it is still relevant and therefore caution against thinking that “this time is different.” Given the current environment and effects from QE, however, the timing may just take longer.
In this note, we explore the potential impact of a flattening and inverted yield curve on the economy and investment portfolios.
Rising front end, anchored long end to continue driving a flatter yield curve
The gap between 10-year and 3-month U.S. Treasury yields has fallen from around 300 basis points (bps) at the beginning of 2014 to around 75 bps by the end of August 2018, its narrowest level since 2007 (see Figure 1).
Figure 1. The U.S. yield curve has flattened considerably
Notes: Another commonly used slope indicator uses the 2-year and 10-year Treasury yield spread. Both indicators lead to the same conclusion in their relationship with inversion and downturns; however, we favor the 3-month/10-year spread because of its stronger consistency with economic theory in measuring the term spread. See Bauer, Michael D. and Thomas M. Mertens, 2018. Information in the Yield Curve About Future Recessions. FRBSF Economic Letter.
Sources: Bloomberg; Vanguard calculations, as of August 31, 2018.
As the Fed continues to drive up short rates, our analysis (see From Reflation to Inflation: What’s the Tipping Point for Portfolios?) indicates that longer-term rates will remain range-bound, largely because of subdued long-term inflation expectations.
We expect the effect to be further curve flattening, and we anticipate that by 2019 the risk of curve inversion will have risen significantly (see Figure 2).
Figure 2. Further flattening expected; inversion risk increases by 2019
Notes: FFR refers to federal funds rate. The U.S.10-year Treasury path range uses the 35th to 65th percentile of projected Vanguard Capital Markets Model® (VCMM) path observations. VCMM is a proprietary financial simulation engine designed to help clients make effective asset allocation decisions.
IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of June 30, 2018. Results from the model may vary with each use and over time. For more information, please see Page 5.
Sources: Vanguard calculations, based on Thomson Reuters Datastream and Moody’s Analytics Data Buffet; Federal Reserve Bank of New York.
The yield curve as a growth indicator
Historically, an inverted yield curve has been a reliable predictor of economic recessions.1 Since 1970, all seven U.S. recessions have been preceded by an inverted yield curve. The time between an inverted curve and the subsequent recession has ranged from 5 to 17 months (see Figure 3).
Figure 3. All seven U.S. recessions since 1970 have been preceded by an inverted yield curve
Note: The yield curve as measured by month-end data using the spread between the 10-year and 3-month U.S. Treasury yields did not invert prior to the 1957 and 1960 recessions, although it narrowed to 6 bps and 30 bps, respectively.
Sources: Bloomberg; Vanguard calculations.
But has this relationship changed? There has been debate recently among market participants and central bankers that aspects specific to this environment have distorted the signal. This is primarily driven by the effect from central bank asset purchases (known as QE), which has suppressed the compensation investors require for bearing duration risk.
We acknowledge the changes that have occurred as a result of QE, and this may prolong the time between the inversion of the yield curve and the subsequent recession. However, our analysis suggests that the curve’s relevance as a growth signal has not deteriorated relative to history (see Figure 4). We therefore caution against ignoring the robust information contained in the yield curve concerning capital market supply-and-demand dynamics and macroeconomic expectations.
Figure 4. Yield curve remains a relevant leading indicator of economic growth
Notes: Data are through June 30, 2018. Asterisks represent statistical significance (*** 99.9%, ** 99%). Sensitivity is represented by coefficients from an OLS model of yield curve slope (10-year Treasury yield minus 3-month T-bill yield), and the Vanguard Leading Economic Indicators (VLEI) series (used as a proxy for growth with monthly observations) 12 months forward.
Sources: Vanguard calculations, based on data from Moody’s Analytics Data Buffet and Thomson Reuters Datastream.
Read the full article here by Joseph Davis, Ph.D. of Vanguard, Advisor Perspectives