On (Yield) Curves and What They Mean in Terms of a Recession– May 01, 2019

Posted by Guest Blogger Russell Moenich, Sequoia Financial Group, LLC

Anish Kapoor makes some cool curves.

Kapoor, a world-renown sculptor who was awarded the Turner Prize in 1991 and received a British knighthood in 2013, has designed a wide range of interesting artwork (check it all out here). He might be best known for his public commission, Cloud Gate, located in Millennium Park, Chicago.

Cloud Gate, an outdoor stainless steel amorphous curvy blob (it is nicknamed "The Bean") that was inspired by liquid mercury is mind-boggling to be around. The surface acts as one giant mirror, but, because it is more elliptical in shape, the reflections are distorted and mangled like an extreme funhouse mirror. When viewing the giant work during a beautiful sunny day with clouds floating by, the sculpture's effect is on full blast. It challenges your perception of everything around you — the surrounding buildings become deformed, time seems to quicken a bit as cloud reflections off of the work move faster than reality and your own reflection on the sculpture appears to suggest you are looking into a totally different alternate reality.

The unartistic world of macroeconomics has its own mind-boggling and perception-challenging curvy thing: the slope of the U.S. Treasury yield curve.

The ever-useful Investopedia defines yield curves this way:

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is used to predict changes in economic output and growth.

A "normal" upwardly sloping yield curve is shown in yellow below, which is the U.S. Treasury yield curve from March 31, 2010:
Bloomberg Chart
Notice how the longer-dated Treasury maturities — the 10-year and the 30-year — had higher interest rates (3.8% and 4.7%, respectively) than the shorter-dated Treasury maturities like the 2-year (1.0%) and the 3-month (close to 0%). Now compare that to the current Treasury yield curve in green above. Both the 10-year and the 30-year bonds have interest rates close to shorter-term Treasury bills and notes. Believe it or not, two weeks ago the three-month Treasury bill had a higher interest rate than the 10-year Treasury bond! This probably sounds crazy given basic economics; you, as a lender to the U.S. government, would want to receive a higher interest rate based on the length of the loan to compensate for the time value of money, e.g., the longer you lend your money, the higher the interest rate.

Why does this happen?

While the short-term end of the yield curve is mainly driven by the Federal Reserve Bank's monetary policy, which reflects the current economic outlook, the long-term end of the yield curve (10 years and out) is driven by bond investors’ long-term views of the market. If bond investors are bullish on the economy and believe interest rates will go up, they are more willing to hold short-term bonds and hope to get higher yields in the future.

On the flip side, if bond buyers believe the economy is heading downward and interest rates are likely drifting lower, they’d prefer to hold the longer-term bonds to lock in the current higher yields. In that case, the higher demand for longer-term bonds will drive up their prices and lower the yields. Long-term bonds yields are usually higher during economic expansions because bond investors need more compensation to be locked in for longer periods of time; but when the sentiment gets bearish, the long-term yields can fall below the short-term yields.

What does this all mean?

When the yield curve has "inverted" (short-term interest rates > long-term interest rates) for a sustained period in the past, the economy generally headed into a recession about a year after the event. It has been a very reliable leading economic indicator in the past. 

We recently experienced a yield curve inversion, cause for suitable media coverage, including Sequoia’s Leon LaBrecque in his Forbes blog on this topic. However, the curve was inverted for only a few days, not necessarily giving us a “sustained” inversion time like in prior pre-recessions. From our perch, it makes sense to wait for weekly or monthly averages to show an inversion rather than daily data. If we use only daily data points, we may encounter false signals with the yield curve. Note the Treasury yield curve did invert on a daily basis during 1998 but not on a weekly or monthly basis, and no recession was forthcoming over the following year. Given that, we are watching with great interest. 

Will the same thing happen this time? It’s like Cloud Gate, as you look at it from different vantage points, you see it differently. If you step away, you can see the whole thing. We’re trying to look at the whole economic landscape. 

In that big picture perspective, in addition to the yield curve indicator, there is a collection of other leading economic indicators that are not flashing red yet, but at least some are yellow. Based on historical data from prior slowdowns, we believe these signs offer us a glimpse at what may be ahead.

Like most things, we think keeping our head up is important. Recessions and slowdowns are part of the natural business cycle. Recessions can also create opportunity. Read more on that in “Challenge and Opportunity in Times of Economic Change” and stay tuned!

Russell Moenich is the Chief Investment Officer of Sequoia Financial Group, LLC. Contact him at rmoenich@sequoia-financial.com to discuss this topic further or visit www.sequoia-financial.com.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.