Surprise: This Inverted Yield Curve Is Good News For The Dow Jones, Economy (兼听则明）# Stock
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The inverted yield curve has set off alarm bells that a recession may loom
around the corner. Historically, that's been a good bet, and recessions
almost always unleash bear markets for the Dow Jones, S&P 500 and Nasdaq.
But this yield-curve inversion, which may be short-lived, looks different.
While it raises some concern about the long-term economic outlook, the
recent inverted yield curve actually is welcome in the near term.
"We may actually have seen a rather unique occurrence: the Fed actually
listening to the markets on a timely basis and pausing rate-hiking," Ed
Yardeni, president and chief investment strategist at Yardeni Research, told
IBD.
Inverted Yield Curve Typically Follows Fed Rate Hikes
Think about how an inverted yield curve typically occurs. Generally, the Fed
hikes short-term rates too much for the underlying economy because of
overheating worries. This can choke off credit for an economy fueled by
credit excesses. That happened with both the dot-com and subprime mortgage
bubbles. As those credit binges passed their prime, Fed rate hikes
exacerbated risks to the economy. That sparked demand for the safe haven of
long-term Treasuries. The yield curve inverted.
Those yield-curve inversions played out almost like clockwork.
In 2000, the Fed hiked its overnight lending rate by 100 basis points to 6.5
% through May. By early July, the yield curve had inverted. Recession
started in March 2001.
In 2006, the Fed hiked 100 basis points to 5.25% through June. An inverted
yield curve flashed in July. Recession began December 2007.
Fed Easing Triggered This Inverted Yield Curve
Now think about what set off the latest brush with an inverted yield curve:
Fed easing, not tightening. No, the Fed hasn't actually cut its benchmark
rate, but it dramatically shifted forward guidance. Back in September, the
Fed projected three rate hikes this year. On March 20, Fed projections
signaled zero hikes in 2019, surprising Wall Street, which still expected
one hike. Two days later, the yield curve inverted.
"We would not overemphasize the slope of the yield curve as a predictor of
recession at present, as the recent flattening is a result of policymakers
easing policy to support growth, rather than a tightening of policy to cool
the economy," wrote Alastair George, chief investment strategist at Edison
Investment Research, in a recent research note.
The European Central Bank also has signaled easier policy, George pointed
out, in addition to the Federal Reserve.
At various points this past week, the 10-year Treasury yield fell seven
basis points or more below the 3-month rate. However, on Friday, that spread
moved to a positive two basis points, ending the inversion for now.
Dow Jones Surged After False Positive 1998 Inversion
When the yield-curve inversions came in 2000 and 2006, the 10-year Treasury
yield had barely begun to recede from recent peaks. Caught off-guard, the
Fed acted too slowly.
The summer of 1998, which saw a rare false positive from an inverted yield
curve, followed a much different script. In the weeks after Russia devalued
the ruble and defaulted on its sovereign debt, the 10-year Treasury yield
plunged 75 basis points, inverting the curve, and kept sliding. The Fed
jumped into action.
It engineered a bailout of the Long-Term Capital Management hedge fund and
cut rates. The panic subsided, the yield-curve inversion reversed and the
dot-com boom exploded. The Dow Jones Industrial Average bottomed even before
the yield curve inverted. By the end of the year, the Dow had surged to
record highs.
Like in 1998, a big drop in the 10-year Treasury yield preceded this latest
yield-curve inversion. After peaking at 3.26% last fall, the 10-year yield
sank all the way to 2.53% as the curve inverted a week ago. The Fed helped
drive long-term Treasury yields lower by taking interest-rate hikes off the
table this year. Facing some global economic wobbles, it looks like the Fed
corrected course swiftly enough to avoid inflicting lasting economic harm.
Really Low Interest Rates Are Positive
At the moment, it would be hard to argue that the 10-year Treasury yield is
too high. The 2.40% rate on Friday is barely 100 basis points above the
record low set in the summer of 2016, when the global economy had its most
recent growth scare. Yet the unemployment rate is near a five-decade low,
jobless claims are close to a cycle low and wage growth has picked up above
3%.
With global growth softening and tax-cut stimulus flattening, GDP growth is
expected to slow to around 2% or perhaps lower this year. But the big drop
in interest rates should provide a cushion. The 30-year fixed-rate mortgage
just saw its biggest weekly drop in a decade and that could give a jolt to
the anemic housing sector. Although slower revenue growth will hold down
earnings growth, lower long-term rates are positive for stock valuations.
Despite the angst over the inverted yield curve, the Dow Jones and other
major averages rose more than 1% this week. The Dow Jones and S&P 500 are
within 4% of their record highs.
Copper, Oil Prices Don't Signal Recession
Copper prices stayed firm as the yield-curve inversion deepened earlier this
week, then shot higher at week's end. Dr. Copper, so named because it's
often a good predictor of a shift in the economy, is near its highest price
since last July. That doesn't gibe with a coming global recession. Nor does
the rally in oil prices back up to $60 a barrel. Still, China data show only
tentative signs that the world's No. 2 economy is healing amid a trade-war
thaw with the U.S. Meanwhile, Europe's economy is stalled.
If there's an Achilles' heel for the U.S. economy, it's an excess of
corporate debt, economists say. While weaker growth leaves the U.S. at
higher risk of recession in the face of a shock, lower interest rates could
help companies manage their debt loads. So far, the spread between high-
yield corporate bonds and 10-year Treasuries hasn't signaled stress.
Inverted Yield Curve Only Partial
Here's another difference from previous cycles when inverted yield curves
turned to recession: The Treasury yield curve never inverted to the same
extent. The yield curve still slopes upward between the 2-year Treasury (2.
26%) and 10-year (2.40%). The latter is just above the 3-month rate, which
dipped Friday amid cooling inflation data.
The take-away: The Fed erred in hiking rates in December. But a quarter-
point move at the front end of the curve won't kill the economy. And if it
persists, the Fed will likely cut rates as financial markets expect.
More Reasons This Time May Be Different
Basic economic theory holds that investors will demand extra compensation to
cover the risk of longer-term bonds. That's known as the term premium. At
the moment, that no longer seems true. Some of the reasons are positive, but
not all of them.
Inflation has been quiet for so long that investors are less concerned about
a future upsurge. Meanwhile, global bond yields are negative in places like
Germany and Japan. Quantitative easing by global central banks has helped
push down yields, sending foreign buyers on a global quest for better
returns. That demand has helped bid up U.S. Treasuries and pull down yields.
Even at 2.40%, the 10-year Treasury yield looks relatively tasty to far-
flung investors.
But there are questions about whether this will be a long-term phenomenon.
Will aging demographics, unaffordable pensions and an excess of government
debt keep interest rates from normalizing long term? Instead of an
inflationary dynamic, the worry is that gravity has shifted and deflation
will be a persistent risk that central banks like the Fed will have a harder
time fighting.
around the corner. Historically, that's been a good bet, and recessions
almost always unleash bear markets for the Dow Jones, S&P 500 and Nasdaq.
But this yield-curve inversion, which may be short-lived, looks different.
While it raises some concern about the long-term economic outlook, the
recent inverted yield curve actually is welcome in the near term.
"We may actually have seen a rather unique occurrence: the Fed actually
listening to the markets on a timely basis and pausing rate-hiking," Ed
Yardeni, president and chief investment strategist at Yardeni Research, told
IBD.
Inverted Yield Curve Typically Follows Fed Rate Hikes
Think about how an inverted yield curve typically occurs. Generally, the Fed
hikes short-term rates too much for the underlying economy because of
overheating worries. This can choke off credit for an economy fueled by
credit excesses. That happened with both the dot-com and subprime mortgage
bubbles. As those credit binges passed their prime, Fed rate hikes
exacerbated risks to the economy. That sparked demand for the safe haven of
long-term Treasuries. The yield curve inverted.
Those yield-curve inversions played out almost like clockwork.
In 2000, the Fed hiked its overnight lending rate by 100 basis points to 6.5
% through May. By early July, the yield curve had inverted. Recession
started in March 2001.
In 2006, the Fed hiked 100 basis points to 5.25% through June. An inverted
yield curve flashed in July. Recession began December 2007.
Fed Easing Triggered This Inverted Yield Curve
Now think about what set off the latest brush with an inverted yield curve:
Fed easing, not tightening. No, the Fed hasn't actually cut its benchmark
rate, but it dramatically shifted forward guidance. Back in September, the
Fed projected three rate hikes this year. On March 20, Fed projections
signaled zero hikes in 2019, surprising Wall Street, which still expected
one hike. Two days later, the yield curve inverted.
"We would not overemphasize the slope of the yield curve as a predictor of
recession at present, as the recent flattening is a result of policymakers
easing policy to support growth, rather than a tightening of policy to cool
the economy," wrote Alastair George, chief investment strategist at Edison
Investment Research, in a recent research note.
The European Central Bank also has signaled easier policy, George pointed
out, in addition to the Federal Reserve.
At various points this past week, the 10-year Treasury yield fell seven
basis points or more below the 3-month rate. However, on Friday, that spread
moved to a positive two basis points, ending the inversion for now.
Dow Jones Surged After False Positive 1998 Inversion
When the yield-curve inversions came in 2000 and 2006, the 10-year Treasury
yield had barely begun to recede from recent peaks. Caught off-guard, the
Fed acted too slowly.
The summer of 1998, which saw a rare false positive from an inverted yield
curve, followed a much different script. In the weeks after Russia devalued
the ruble and defaulted on its sovereign debt, the 10-year Treasury yield
plunged 75 basis points, inverting the curve, and kept sliding. The Fed
jumped into action.
It engineered a bailout of the Long-Term Capital Management hedge fund and
cut rates. The panic subsided, the yield-curve inversion reversed and the
dot-com boom exploded. The Dow Jones Industrial Average bottomed even before
the yield curve inverted. By the end of the year, the Dow had surged to
record highs.
Like in 1998, a big drop in the 10-year Treasury yield preceded this latest
yield-curve inversion. After peaking at 3.26% last fall, the 10-year yield
sank all the way to 2.53% as the curve inverted a week ago. The Fed helped
drive long-term Treasury yields lower by taking interest-rate hikes off the
table this year. Facing some global economic wobbles, it looks like the Fed
corrected course swiftly enough to avoid inflicting lasting economic harm.
Really Low Interest Rates Are Positive
At the moment, it would be hard to argue that the 10-year Treasury yield is
too high. The 2.40% rate on Friday is barely 100 basis points above the
record low set in the summer of 2016, when the global economy had its most
recent growth scare. Yet the unemployment rate is near a five-decade low,
jobless claims are close to a cycle low and wage growth has picked up above
3%.
With global growth softening and tax-cut stimulus flattening, GDP growth is
expected to slow to around 2% or perhaps lower this year. But the big drop
in interest rates should provide a cushion. The 30-year fixed-rate mortgage
just saw its biggest weekly drop in a decade and that could give a jolt to
the anemic housing sector. Although slower revenue growth will hold down
earnings growth, lower long-term rates are positive for stock valuations.
Despite the angst over the inverted yield curve, the Dow Jones and other
major averages rose more than 1% this week. The Dow Jones and S&P 500 are
within 4% of their record highs.
Copper, Oil Prices Don't Signal Recession
Copper prices stayed firm as the yield-curve inversion deepened earlier this
week, then shot higher at week's end. Dr. Copper, so named because it's
often a good predictor of a shift in the economy, is near its highest price
since last July. That doesn't gibe with a coming global recession. Nor does
the rally in oil prices back up to $60 a barrel. Still, China data show only
tentative signs that the world's No. 2 economy is healing amid a trade-war
thaw with the U.S. Meanwhile, Europe's economy is stalled.
If there's an Achilles' heel for the U.S. economy, it's an excess of
corporate debt, economists say. While weaker growth leaves the U.S. at
higher risk of recession in the face of a shock, lower interest rates could
help companies manage their debt loads. So far, the spread between high-
yield corporate bonds and 10-year Treasuries hasn't signaled stress.
Inverted Yield Curve Only Partial
Here's another difference from previous cycles when inverted yield curves
turned to recession: The Treasury yield curve never inverted to the same
extent. The yield curve still slopes upward between the 2-year Treasury (2.
26%) and 10-year (2.40%). The latter is just above the 3-month rate, which
dipped Friday amid cooling inflation data.
The take-away: The Fed erred in hiking rates in December. But a quarter-
point move at the front end of the curve won't kill the economy. And if it
persists, the Fed will likely cut rates as financial markets expect.
More Reasons This Time May Be Different
Basic economic theory holds that investors will demand extra compensation to
cover the risk of longer-term bonds. That's known as the term premium. At
the moment, that no longer seems true. Some of the reasons are positive, but
not all of them.
Inflation has been quiet for so long that investors are less concerned about
a future upsurge. Meanwhile, global bond yields are negative in places like
Germany and Japan. Quantitative easing by global central banks has helped
push down yields, sending foreign buyers on a global quest for better
returns. That demand has helped bid up U.S. Treasuries and pull down yields.
Even at 2.40%, the 10-year Treasury yield looks relatively tasty to far-
flung investors.
But there are questions about whether this will be a long-term phenomenon.
Will aging demographics, unaffordable pensions and an excess of government
debt keep interest rates from normalizing long term? Instead of an
inflationary dynamic, the worry is that gravity has shifted and deflation
will be a persistent risk that central banks like the Fed will have a harder
time fighting.