A complex relationship exists among interest rates, central bank policy, risk asset prices and investor expectations. Learn more from James Camp, CFA.
“Inverted yield curves have preceded every recession over the past 50 years” is a statistically accurate and ever more frequent refrain of the financial press. The U.S. Treasury market is one of the most liquid and efficient debt markets in the world, and investor activity and preferences therein provide important insights into the outlook for economic and inflation expectations. To wit, a collapse in global yields, together with a massive rally in the benchmark 10-year U.S. Treasury note, is indicative of a significant global economic slowdown and muted inflation.
Moves in rates occur because the economy is dynamic, always going through periods of acceleration, deceleration, or no change – essentially mini-cycles within the expansion. The most recent of these moves was a 175 basis point collapse in the 10-year note from last year’s peak. Ranges for yields within an expansion are normal. However, a +100 basis point swing close to the zero bound is a relatively large move that needs to be closely managed. The yield on the 10-year note has hit 1.5% twice before during this expansion – each time, central bank policy responses were at the ready and economic growth and rates moved higher. The efficacy of central bank policy responses are diminishing, but with virtually 99% of the yield curve now inverted, they are front and center once again.
Short-term rate inversions are consequential for risk assets as funding costs increase for levered financial positions. The economic slowdown last fall in combination with the Federal Reserve's (Fed) signaling of additional tightening led to market expectations of this dynamic, which became the proximate cause for the fourth quarter selloff.
A more consistent march higher in short-term rates would have caused a more prolonged correction in risk assets. Fortunately, the market forced the Fed away from this expansion killing policy error. But some damage had been done, and it was in March, after the rally in longer-term interest rates, when the 3-month bill inverted to the 10-year note. The message from the market was clear: financial conditions were still tight, and if the Fed didn’t act, such conditions could hurt the economy further.
In mid-August, the 2-year/10-year Treasury curve inverted as Fed officials failed to be dovish enough in their expectations for the future path of interest rates at the July Federal Open Market Committee meeting, and after they had dragged their feet for several months into the first rate cut of the cycle. Yet the slope of the curve is only one indicator. In prior periods, the inversion of the curve was later coupled with a variety of other signaling economic conditions such as labor market weakness and – most notably, from our perspective – deterioration in credit performance. Such is not the case currently.
The traditional banking system would tighten credit as the short-borrowing-long-lending model was disrupted in prior cycles. Now, much of the credit creation in the U.S. economy occurs in the “shadow banking” securities markets. For these markets to continue to issue bonds, the slope of the corporate credit curve is most relevant. Since this slope is still positive (short- to long-term credit spreads), financial conditions are still accommodative for deal flow. Here, credit is readily doled out to ever increasing demand from pension funds and retail investors. In fact, the number of new credit funds has accelerated and pushed the size of credit markets to record levels.
The issue for the real economy lies not just with the inverted yield curve, but with the continuation of the credit boom cycle enabled by central banks and yield-starved investors and the misallocation of capital that follows.
James Camp, CFA, Managing Director, Strategic Income is with Eagle Asset Management, an affiliate of Raymond James & Associates, Inc., and Raymond James Financial Services, Inc. All expressions of opinion reflect the judgement of Eagle Asset Management, Inc., and are subject to change.