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Yield curve warnings

The fact that five-year US Treasury yields are below two-year ones is a worrying sign. But the Fed knows this.
February 7, 2019

The US yield curve is like the curate’s egg: it’s good in parts. Although 10-year yields are comfortably above the Fed funds rate – a fact that has historically been a strong predictor of rising share prices and economic growth – five-year yields are below two-year ones, which points to falling share prices and output.

How much we should worry about this depends in part on how you read the statistics.

Let’s consider three-yearly changes in US share prices: I take three years because the lag between the yield curve and equity returns can be long and variable. Since 1987 these have been predicted in part by the Fed funds rate and two-, five- and 10-year yields taken together. If this past relationship continues to hold, it points to shares rising slightly over the next three years. The bullish signal sent by two- and 10-year yields being high relative to the Fed funds rate offsets the bearish signal of relatively low five-year yields.

 

Even this, however, tells us there’s a 40 per cent chance of the market falling over the next three years. And past relationships between these interest rates and subsequent three-year changes in industrial production suggest a greater than 50:50 chance of output falling between now and 2022.

Another reading of the data, however, paints a gloomier picture. If we look simply at whether a portion of the yield curve is inverted or not, we see that the gaps between the Fed funds rate and 10-year yields and between five- and two-year yields both predict output and equity returns over the following three years. If these relationships continue to hold, they point to greater than 50:50 chances of both shares and output falling over the next three years.

There’s a simple reason why this relationship is slightly more bearish than a linear one between interest rates and returns. It attaches the same weight to a small inversion as to a big upward slope. This means the mere fact that five-year yields are only slightly below two-year ones is a bearish signal.

However we read the statistics we have reason to be at least mildly concerned by the fact that five-year yields are below two-year ones.

But we also have a big comfort. It’s that the Fed knows this. And it also knows that investors know it. It will therefore be very reluctant to raise rates if this would risk inverting the yield curve even more. This is because doing so would risk depressing share prices, which itself would represent a tightening of monetary conditions. The Federal Open Market Committee (FOMC) said last month that rates would be set according to “readings on financial... developments”. That’s a way of saying it would be unlikely to raise rates if bond yields are low.

Inflation is not such a big danger that it is worth risking a recession to reduce it: in fact, next week’s figures should show that consumer price inflation actually fell last month.

Many of us might be underestimating this comfort. Our views of the world are shaped not just by current facts but by our formative experiences. As Napoleon Bonaparte said: “To understand the man you have to know what was happening in the world when he was 10.”  Research by Ulrike Malmendier shows that he was right. She’s shown that investors who experienced recessions in their formative years hold fewer equities than others even decades later, and that chief executives who grew up in the Great Depression adopted cautious borrowing policies even during good times.

And here’s the thing. Many investors grew up in the 1970s and 1980s when the Fed engineered recessions in order to cut inflation. Memories of those episodes might be unduly influencing opinions about the Fed today, causing people to exaggerate fears that the Fed will jeopardise the economy and share prices by inverting the yield curve. Sometimes, younger people are wiser than we old men.