Recession or Expansion – The Mighty Yield Curve

Authored by: Philip Lockwood

I want to start out by saying that a majority of folks have a financial plan in place and my opinion is that most of them do not need to greatly deviate from that plan. With that being said, what is a flattening yield curve and why might it be worthy of our attention? A yield curve is a curve on a graph in which the yield of a fixed-interest investment is plotted against the length of time they have to run to maturity. What determines yield curve? Several factors shape the treasury yield curve – monetary policy, inflation expectations, investor preference, and macroeconomic influences from around the world. The treasury yield curve describes how treasury interest rates differ from across the maturity of treasury assets.

When most “talking heads” refer to the flattening yield curve, they are talking about the rate of return on government issued debt. The government issues 3 types of debt:

• Treasury Bills (T-Bills) – T-Bills are short term debt issued with a maturity ranging from a few days to 52 weeks.
• Treasure Notes (T-Notes) – T-Notes are medium term debt issued with a maturity between one and 10 years.
• Treasury Bonds (T-Bonds)- T-Bonds are longer term debt issued with a maturity longer than 10 years.

A normal yield curve generally looks like this:

As you can see, you are paid a higher interest rate for purchasing debt with a longer time horizon. Shifts at the short end of the yield curve reflect immediate monetary policy, while changes in the long end of curve reflect the influence of various economic factors that are not limited to the United States alone. The general way of thinking is: if I give the government money (i.e. purchase a government issued debt), my risk is less for 1 month (T-Bill) than it would be for 20 years (T-Bonds). Some examples of risk would be: inflation, loss of use in other investments, government destabilization, devaluation of the dollar, etc. This is often called a “Maturity Risk Premium,” which means it is expected that you would receive a better rate of return for a longer maturity. One way to think about the long end of the curve is to think that the long end of the curve represents investors expectations of future short-term interest rates.

When a yield curve flattens, it means that you are compensated the same or close to the same for short-term government debt as you are for long-term government debt. The rate for T-Bills is similar to the rate for T-Bonds. A flat yield curve looks like this:

How does this happen? When the Federal Reserve hikes the short-term federal funds interest rate, the short end of the curve begins to rise as the yield on short-term T-bills reflects tighter monetary policy. The long end of the yield curve does not rise since changes to the federal funds rate do not have a direct impact on long-term yields. As mentioned earlier, long-term yields are influenced by inflation expectations, risk premium, and investor preferences. Some actual examples of why long-term yields have not increased much can possibly be contributed to:

• Expectations of low inflation
• The instability with Brexit
• Slow Growth in China
• The appetite for long term debt by insurance companies and pensions

When things like this occur, they can result in the flight of capital to safe havens such as long-term U.S. treasuries. This demand keeps long-term rates unchanged while the Fed increases the short-term rates.

The yield curve is not currently flat, and in fact, historically the market has done well between times of a nearly flat yield curve and an inverted yield curve.

The chart below demonstrates that it can be advantageous to be in equities before a recession as long as you know when to get out!

Why does any of this matter, and how can it have an effect on retired fixed-income investors? As scary as this sounds, a flattening alone does not mean that the United States is doomed to slip into another recession; but if it keeps moving in this direction, eventually long-term interest rates will fall below short-term rates. When this happens, it creates an inverted yield curve, this inversion is seen as a powerful signal of a recession. An inverted yield curve has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960’s, when an inversion was followed by an economic slowdown, but not an official recession. Something to remember is an inverted yield curve doesn’t predict precisely when recession will begin. In the past, the recession has come in as little as six months, or as long as two years, after the inversion.

This all sounds great, but how does this affect me? Let’s take a quick look at the banking sector. Banks borrow money at short-term rates and lend it at long-term rates. When short-term rates are higher than long-term rates it means lending money becomes a losing proposition. When lending money slows or stops, it can have a great impact on growth or expansion, as businesses looking to grow can only spend their cash on hand and can’t leverage a banks assets. Borrowed money is the lifeblood of economic activity, and this can slam the brakes on economic growth.

In addition, if you are a retired investor relying on fixed income, the long-term rates are likely to be lower and the lower rate of return may not keep up with inflation. A quick example would be if you are getting a fixed income rate of return of 5% annually for 30 years, and you go to the grocery store to find that the price of milk has gone up 10% due to inflation. Due to the increase in the price of milk, you now have less to spend in other areas. Compound this by all of your non-discretionary needs, and this can become a real problem.

I am writing this as I am watching my favorite baseball team the Chicago Cubs. If you know anything about the Cubs, you know that we have many young players that like to swing at every pitch. If you think about making decisions, you hopefully have a comprehensive plan in place and that plan includes diversification inside of your portfolio and assets. Be sure to talk with your financial Advisor and make sure he/she has a good understanding and grasp of the yield curve and make sure your portfolio is properly diversified. At times like this, I am reminded of a quote “It’s one thing to get ahead of the curve and hit the ball, and another to swing so early you strike out.”

Takeaways to consider:

• Historically, dividend-paying stocks will lag as short-term rates rise.
• Historically, when the yield on the S&P 500 has come within one percentage point of the 10-year Treasure note yield, the blue-chip index has risen 11% in the following 12-month period, but the margin of error between a flatter and inverted curve is minimal at this point
• You may want to contact your advisor to see how correlated your portfolio is to a major index

During times like this It is important to have a solid financial plan, a portfolio in line with your risk tolerance, and open conversation with your financial advisor.

In short, the yield curve is a flashing yellow light right now, but not red. The big question is whether the Fed goes too far in raising rates contributing to the creation of an inverted yield curve.