Does the Yield Curve Flattening Mean a Recession is Ahead?
An inverted yield curve has typically preceded recessions, so what is the current yield curve indicating?
Will the Yield Curve Tell Us a Recession is Coming?
This week's column is about interest rates and the yield curve – two very important fundamentals for weighing future economic activity and market returns. Before I dive in, though, I want to provide a brief update on the war in Ukraine.
Geopolitical crises are neither desirable nor positive for the world or markets. But they are also not necessarily a negative. Looking back at conflicts since 1925 – the Korean War, Vietnam, the Cuban Missile Crisis, the Iran/Iraq War, two U.S. wars in Iraq, the list goes on and on – it was only World War II that resulted in a bear market. Many of these conflicts involved U.S. troops, with our country directly engaged in fighting the war. That's not the case today – we believe the current conflict in Ukraine will remain regional, with the West's involvement only coming in the form of aid and punishing economic sanctions on Russia.
Russia's invasion will likely disrupt oil markets and have knock-on effects on inflation, and we are watching closely to see if export controls are ultimately placed on Russian oil. For now, the market is pricing-in the likelihood of higher global oil prices and what that could mean for U.S. consumer spending and corporate earnings. In our view, we can expect some short-term economic impact and likely more market volatility to accompany it, but still do not believe the risk of recession is high. A recession requires trillions of dollars to be wiped off global growth, which we do not think higher oil alone will cause.
In times like these when market volatility is constant and recession fears saturate the media, it is important not to let media hysteria cause you to make knee-jerk reactions based on emotion! Instead, I recommend focusing on the long-term outlook. This means focusing on factors and data that can keep your investments on track if the market takes a sharp turn.
To help you do this, I am offering all readers our just-released March 2022 Stock Market Outlook report1. This report will provide you with our forecasts along with additional factors to consider:
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Zacks view on equity markets
What produces optimism in 2022??
Zacks forecasts for 2022
Zacks ranks industry tables
Sell-side and buy-side consensus
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There have been reports recently about the yield curve being in a flattening pattern, which many are saying could spell bad news for the economy. History supports the argument: an inverted yield curve has typically preceded recessions by about 5 to 15 months, and with the Federal Reserve on the cusp of a rate hike cycle, many investors are mumbling about a worsening economic outlook from here.2
The basis for these concerns happens when the yield curve is measured as the difference between the yield on the 10-year U.S. Treasury bond and the 2-year U.S. Treasury bond, as seen below. When the yield on the 10-year minus the yield on the 2-year is zero, the yield curve is completely flat. As you can see on the chart, the difference in yields is approaching zero – i.e., in a flattening pattern.
Source: Federal Reserve Bank of St. Louis3
But there's a problem with this analysis: comparing the 10-year U.S. Treasury bond yield with the 2-year is not the most accurate and meaningful way to measure the yield curve. In my view, it is much better to compare the 10-year U.S. Treasury bond yield with the 3-month U.S. Treasury bond yield – something many pundits and columnists are not doing when issuing warnings about the yield curve.
An analysis of the yield curve as the 10-year U.S. Treasury bond yield minus the 3-month U.S. Treasury bond yield shows the curve has steepened over the past year, not flattened (see chart below). The 10-year bond yield has been moving higher at a faster clip than the 3-month and other short-term rates, causing the steepening. Looking at the yield curve in this way (the correct way, in my view) changes the economic narrative completely and signals that the financial conditions have been getting better recently, not worse.
Source: Federal Reserve Bank of St. Louis4
Some investors may be wondering, why does any of this yield curve analysis matter? For two reasons, in my view. The first is that the yield curve gives us insight into bank profitability, which is correlated with economic activity. The second is that historically, the yield curve has been a reliable predictor of economic recessions, so it is worth keeping an eye on.
Let's start with the first reason regarding bank profitability. Put simply, banks borrow money and pay deposits using short-term interest rates (overnight and up to 3 months), and then in turn loan money to consumers, homeowners, and businesses at longer-term interest rates (10+ years). This is the key reason investors should look at the 10-year and 3-month U.S. Treasury yields for the yield curve, as these are the rates that matter. Banks generally do not borrow money at 2-year U.S. Treasury rates.
Banks make money when long-term interest rates are meaningfully higher than short-term interest rates – a steep yield curve. When short-term interest rates are higher than long-term interest rates and the yield curve inverts, net interest margins get squeezed, profits fall, and a bank's incentive to lend money falls. As banks loan less, economic activity tends to follow.
The second reason yield curve analysis is important is that historically, an inverted yield curve has been a good indicator of an economic slowdown ahead. Readers can see in the chart below that when the yield curve inverts (the line dips below zero), recessions tend to follow shortly after. Since 1970, there have been eight recessions and all of them were preceded by an inverted yield curve.
The Yield Curve Has Been a Reliable Predictor of Economic Recessions
Source: Federal Reserve Bank of St. Louis5
The upshot in the current environment is easy to see in the chart – the line is not only above zero, but it is also rising. That means the yield curve has been steepening recently, which is counter to what is being said and written about in the financial media.
Bottom Line for Investors
The yield curve is an important economic indicator and should be monitored regularly. It matters to bank profitability, which in turn matters to loan growth and economic activity. But the yield curve is also analyzed incorrectly quite often, in my view. Looking at the 10-year U.S. Treasury bond yield minus the 2-year U.S. Treasury bond yield does not provide a meaningful reading – banks do not borrow at 2-year rates.
Instead, investors should always focus on the 10-year U.S. Treasury bond yield (or longer) minus the 2- or 3-month U.S. Treasury bond yield. In the current environment, this more accurate view shows the yield curve has been steepening, not flattening, which should bode well for economic activity ahead.
Instead of letting short-term volatility influence your investment decisions, I recommend that investors do the appropriate research to better invest towards their long-term goals. To help, I am offering all readers our Just-Released March 2022 Stock Market Outlook Report6.
You'll discover Zacks' view on:
Zacks Rank S&P 500 Sector Picks
Zacks view on equity markets
What produces optimism in 2022?
Zacks forecasts for 2022
Zacks ranks industry tables
Sell-side and buy-side consensus
And much more
If you have $500,000 or more to invest and want to learn more about these forecasts, click on the link below to get your free report today!
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4 Zacks Investment Management reserves the right to amend the terms or rescind the free Stock Market Outlook offer at any time and for any reason at its discretion.
7 Zacks Investment Management reserves the right to amend the terms or rescind the free Stock Market Outlook offer at any time and for any reason at its discretion.
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