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Dangerous Curves

Phil Kernen

FINANCIAL MARKETS are full of indicators and data relationships from which we tease conclusions. Few signals grab our attention more than an inverted yield curve and its habit of showing up before recessions. But is this signal still accurate in predicting economic trouble?

When U.S. Treasury bond yields are plotted on a graph, they normally have an upward slope, with short-term yields generally lower than longer-term yields. That makes sense: Lenders demand a higher rate for 30-year loans than 10-year loans because their money is at risk for longer.

The difference in yields from one point on the Treasury yield curve to the next is called a term premium or spread. If the two-year Treasury yield is 2.1% and the 10-year Treasury yield is 2.3%, as it was yesterday afternoon, the spread is 0.2 percentage point.

When short-term yields rise above longer-term yields, the spread turns negative. This is called a yield curve inversion. In 2018, the San Francisco branch of the Federal Reserve published a study on the ability of yield curve inversions to predict recessions. It found that negative spreads—meaning an inverted yield curve—had preceded every recession since 1955.

Why historically has an inverted yield curve preceded recessions? Perhaps investors see signs of economic slowing and buy longer-term government bonds, anticipating that yields will fall as inflation subsides and as folks pile into super-safe bonds. Or perhaps short-term borrowing becomes more expensive, choking off near-term investments and slowing economic growth.

But I believe that yield curve inversion has lost its predictive power—thanks to the monetary policy of the past 14 years. Since 2008, the Federal Reserve has purchased trillions of dollars in U.S. Treasurys and mortgage-backed bonds to suppress intermediate and long-term yields. The Fed intended to push investors into riskier assets like stocks, which would both help to reopen the economy quickly and kick-start growth. All that Fed buying, however, has suppressed and sidelined one important market function—price discovery.

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Price discovery is the market process for determining the price of an asset at any given point in time. It’s about finding where natural supply and demand meet. Discovery requires a majority of market participants to be price sensitive. When price discovery works properly, bond prices—and hence interest rates—are set by thousands of independent buy and sell decisions.

But price discovery isn’t currently happening in interest rate markets. Central banks have always directly set overnight rates—meaning short-term interest rates—and sought to indirectly influence longer-term rates. But since the 2008-09 Great Recession, central banks have been purchasing so many longer-term bonds for so long, without regard to their price level, that they have neutered price discovery.

In 2021, for example, the Fed purchased one-half of the total new issuance of U.S. Treasury notes to drive yields down and bond prices up. Across the U.S. Treasury yield curve, the Fed is the price-setting elephant in the room. Where would interest rates be if the Fed wasn’t the most prominent buyer by far? What would term spreads tell us?

Given the Fed’s interventions, it’s no coincidence that the yield curve inverted in August 2019 for the first time since 2007. A short recession did indeed occur in early 2020, though it was driven not by a typical economic slowdown, but by the unexpected arrival of COVID-19. Price discovery won’t happen again until the Fed stops intervening so forcefully in the bond market.

Keep this in mind when, in the coming months, you hear about the risks and downside of an inverted yield curve. It may have been a reasonably reliable predictor of recession when the Fed only drove short-term rates and price discovery was allowed to work in the rest of the bond market. But price discovery isn’t working today—which means yield curve inversion is another manipulated indicator that no longer tells us what it once did.

Phil Kernen, CFA, is a portfolio manager and partner with Mitchell Capital, a financial planning and investment management firm in Leawood, Kansas. When he’s not working, Phil enjoys spending time with his family and friends, reading, hiking and riding his bike. You can connect with Phil via LinkedIn. Check out his earlier articles.

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