Recent Yield Curve Inversion Underscores Merits of Diversification
On March 22, we witnessed an event that hasn’t occurred since 2007: an inverted yield curve. The yield on the three-month U.S. Treasury bill crept slightly higher than the yield for a 10-year U.S. Treasury.
What this means, in the minds of some, is that a recession is just around the corner.
We don’t dismiss the significance of the yield curve: It is one of many data points we monitor closely, and our portfolio is well-diversified and positioned for uncertain times. However, this latest inversion, while rare, doesn’t rise to the level of inversions that preceded recessions in the past. Many other economic indicators are strong.
In December we outlined six reasons why we didn’t forecast a recession for 2019. The yield curve, which had not inverted at that point, was at the top of our list. Now that an inversion has occurred, why not amend our outlook?
The duration of the inversion is key
The inversion that occurred on March 22 was short-lived. On April 1, for example, the yield on the 10-year Treasury was 2.444 percent, while the yield on the three-month T-bill was 2.401 percent. That spread was fairly flat, but it wasn’t inverted.
As we noted in December, there have been seven times since 1976 when the yield curve was flat or inverted, with an average duration of 10 months. Five of those times, recession followed, as soon as nine months later, as long as 22 months later. Twice, inverted yield curves did not result in recession. The two times when no follow-on recession occurred, the inversions periods were short (1-3 months). History shows that we need an inversion lasting three months or more before it is a sign of likely recession, and even then, recession tends to come 17-20 months later.
The March inversion involving the three-month Treasury didn’t meet the historical standard needed to qualify as a recession flag.
There has been no inversion involving the two-year Treasury
Our preferred measure for the yield curve is with the two-year Treasury and the 10-year Treasury. The two-year is a better reflection of the state of the economy, we believe, because three-month T-bills tend to be very anchored by the Fed Funds Rate. While the spread between the two-year Treasury and the 10-year Treasury is narrow—and has been for quite some time—there has been no inversion. That suggests that recession talk is premature.
We monitor yield curves closely, but it is important to keep an eye on other factors as well.
The Fed has idled its interest rate hikes
When the Fed tightens to check inflation worries, the yield curve tends to flatten and eventually invert, as near-term inflation pressure and Fed tightening put upward pressure on short rates, while the long-end of the curve prices in slower growth due to the contraction of credit. In September of last year, the Fed suggested it could raise rates two or three times in 2019, but it has not done so. On March 20, the Fed signaled that no hikes were anticipated for 2019. There is some consensus that the Fed made one tightening move too many, and now some traders are betting on one rate decrease this year.
Other key indicators have improved
Equity markets have roared back, posting one of the best first-quarter improvements in the past century. This came after one of the worst fourth-quarter declines in a century, so it is fair to question how much more momentum equities may possess. Even so, the stock-market declines late last year were driving recession fears, so the resiliency of equities is significant. As it relates to the yield curve, it’s worth noting that historically, the stock market performs well from the time of an inversion to the next recession.
The Conference Board Leading Economic Index (which weighs unemployment, building permits, stock prices, consumer sentiment and other factors) has improved recently month over month, after declining steadily more recently. This too suggests that recession is not near.
The housing market, another key indicator, is improving after a very tough 2018. In December, we shared our view that the home-buying slump was due primarily to short-term sticker shock caused by rising interest rates, and that improvement was likely. With mortgage rates now falling, that is proving to be the case.
Last fall, a precipitous drop in oil prices was another reason for people to fear a looming recession. Our view was that energy demand remained strong and that falling prices were caused by an excess supply of crude. OPEC production cuts have addressed this, and oil prices have roared back, signaling confidence in demand.
The yield curve is an important economic indicator, and we continue to monitor it closely. Tiedemann portfolios are well diversified and positioned for a period of uncertainty.
But the fact remains, the recent inversion of the yield curve involving the three-month Treasury was brief and in any case, is only one of many data points that need to be considered when looking for recession flags. As we monitor the data closely, we continue to emphasize a diversified portfolio suitable for uncertain times.
Paul Buongiorno is a Managing Director of Tiedemann Advisors LLC. Tiedemann Advisors is an investment advisor. The information presented herein is intended as an illustration of the services offered by Tiedemann. Such services may not be suitable for all individuals. This information is intended to serve as the basis of a discussion with a Tiedemann professional and does not constitute, and should not be construed as, the provision of tax, accounting or legal advice or investment recommendations. You should consult with your tax or legal advisors prior to entering into any planning or trust arrangements. Economic and market forecasts presented herein reflect our judgment as of the date of this presentation and are subject to change without notice. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals and objectives, risk tolerance, investment time horizon, tax situation and other relevant factors. These forecasts are subject to high levels of uncertainty. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Asset allocation does not guarantee a profit or protection from losses in a declining market. Investments in securities involves significant risk and has the potential for partial or complete loss of funds invested. Investments, when sold, may be worth more or less than the original purchase price. The CONFERENCE BOARD’S LEADING ECONOMIC INDEX (LEI) is one prominent economic indicator. It is designed to predict future movements in the economy based on a composite of 10 economic indicators whose changes tend to precede shifts in the overall economy.