Has the world turned upside down? This week the media seized on the occurrence of an “inverted” Treasury yield curve which happens when yields on bonds with shorter maturities exceed those of longer maturities. In particular, the 2yr yield (and eventually the 3yr) exceeded that of the 5yr maturity. The event caused quite a stir since an inverted yield curve has preceded each recession for the past 50 years. That said, while any inversion is notable, the yield difference that most economists track are either the 2yr/10yr or the 3-mo/10yr – both of which remain modestly positive.
While the curve has been flattening most of the year, a meaningful change happened since October 1st – shortly after the last Fed rate hike. The 2yr Treasury yield has stayed roughly flat while the 5yr and 10yr yields have declined 0.17% (thus causing the slope of the curve to flatten and invert in the middle, source: Bloomberg as of December 4th).
So what does this mean? Are we going into recession? The short answer is no, not yet. Economic cycles are inevitable so a recession will occur eventually but an inverted yield curve does not cause it to happen. Other markers of a recession such as job creation, credit performance, earnings quality, and the housing market all look fine. In fact, according to Credit Suisse the timing of when a recession occurs after an inversion of the 2yr/10yr (which remember hasn’t happened yet) is inconsistent and ranges from 14 months to 34 months. Even the equity market which, as a discounting machine tries to look ahead, goes up 15-16% on average in the following 18 months according to the same research (range of -11% to +30%). Instead, the difference in yields is sending a signal from the market – in this case to the Federal Reserve.
Looking deeper, an important issue underlying the falling fixed-rate, nominal yields is the decline in inflation expectations over the period. By looking at the difference between fixed rate Treasury yields and Treasury Inflation Protected Securities (TIPs whose coupon floats based upon Consumer Price Index or CPI), we can calculate a market-implied inflation expectation (sometimes called the implied inflation breakeven). Interestingly, the implied inflation expectation for the 2yr maturity has fallen 0.6% despite its nominal yield staying relatively unchanged. This implies that the “real yield” (the cost of capital apart from inflation) has moved higher and thus tightened financial conditions. The change illustrates why the Fed may be more inclined to pause sooner rather than later (at least until expectations shift).
Absent other circumstances, falling inflation often implies falling growth expectations. However, this time there are circumstances that are relevant. Falling inflation expectations (as implied by CPI) can be explained in large part by falling energy prices as oil prices have declined almost 30% over the same period. Looking at the consumer basket used to calculate CPI, gasoline represents 4.43%. Influenced by oil, national average gasoline prices have fallen 16% since October 1st implying a reduction in the CPI calculation of roughly 0.70%. The effect of energy prices on inflation tends to be temporary which is why the impact on inflation expectation is less over longer maturities (i.e. averaged over time). The implied inflation expectation on the 10yr has decreased only 0.19%, roughly in-line with how much its nominal yield fell.
All of that is to say that one of the forces pushing yields lower (energy prices) is transitory, but since it has only pulled longer term yields lower it has caused a flattening of the curve to the point of inversion in some parts. The world is not upside down, but it is still as confusing as ever.