What Is the Yield Curve Telling Us About the U.S. Economy?

By Pam Martens and Russ Martens: May 16, 2018 ~ 

The Federal Reserve Building in Washington, D.C.

The Federal Reserve Building in Washington, D.C.

On November 9 of last year, a mere six months ago, we asked the question: “Does Jerome Powell Hear the Alarm Bells from Flattening Yield Curve?” Jerome Powell is, of course, the new Chairman of the Federal Reserve — the U.S. central bank and the body in which the United States has entrusted its monetary policy, for better or worse.

We wrote at the time:

“As of 7:48 a.m. this morning, the spread between the 10-year Treasury Note (yielding 2.33 percent) and 30-year Treasury Bond (yielding 2.81 percent) is even smaller, at a meager 48 basis points or less than half of one percent.

“It is a serious commentary on the bizarre financial times in which we live that a fixed income investor would be rewarded with less than half a percent of additional income to add 20 years of risk to the maturity date on his bond.”

Buckle up your seat belt because things have gotten a lot dicier since we penned that commentary. As of this morning at 6:41 a.m., the 10-year U.S. Treasury was trading at a yield of 3.06 percent while the 30-year U.S. Treasury was yielding a feeble 3.19 percent. The spread, meaning the difference between the two yields, has shrunk from 48 basis points on November 9 to a startling 13 basis points today.

We say “startling” because at this rate, we could be looking at an inverted yield curve faster than the Fed has factored into its thinking. An inverted yield curve, where short-term interest rates on Treasuries are higher than long-term rates, is typically a precursor to a recession. We saw this phenomenon ahead of the 2001 recession and in 2006-2007 ahead of the epic financial downturn in 2008-2009.

Next month, John Williams, the current President of the Federal Reserve Bank of San Francisco, will take the helm at the New York Fed. That powerful position gives Williams a permanent (non-rotating) vote on the Federal Open Market Committee (FOMC), the body that sets monetary policy for the Fed. This makes Williams’ views on economic matters of particular interest to Wall Street economists. In an April 6 speech in Santa Rosa, California, Williams indicated he was definitely not seeing a recession in the cards. He told his audience this:

“Looking ahead, I expect growth to average around 2.5 percent over this year and next. Strong financial conditions, better-than-expected global growth, and fiscal stimulus of lower taxes and higher spending have all created tailwinds that account for growth running above trend.

“Growth above trend doesn’t necessarily pose a particular risk at this time. But it’s one of the factors I’m assessing when I’m thinking about how to best support economic growth over the medium term. In that regard, a question I’m frequently hearing as the expansion closes in on nine years is: are we ‘due’ for a recession?

“The short answer is no. Recessions don’t happen because a timer goes off. Research shows that the odds of going into a recession are the same whether you’re in the seventh, eighth, or ninth year of the expansion. Instead, recessions generally happen because of some big event: the housing crash of a decade ago or the bursting of the dot-com bubble in the early 2000s. These kinds of events are notoriously hard to predict, and the recessions that often follow don’t happen because the business cycle has a time limit on it.”

What does Williams think about an inverted yield curve being a reliable signal of a looming recession? The Wall Street Journal interviewed Williams on December 15 of last year and this is what he had to say on that subject:

“A truly inverted yield curve is a pretty powerful predictor of a recession or for economic performance. I don’t think you can ignore this question, because it’s been documented and studied a lot. I follow this over, you know, my career. So if you go through history sometimes it’s inverted for the old-fashioned reason, the Fed jacks up interest rates – (laughs) – it weakens the economy and it goes to a recession.

“But, so I think history is probably not telling us a lot about the current situation. You know, we’re not increasing interest rates quickly. We’re not doing anything like that. So here’s how I read what’s happening in the yield curve today. So, first of all, I think long-term – let’s start with long-term yields. So I think two important factors are holding them down. One is I think the neutral interest rate is low. It’s, you know, like, 2½ percent or maybe 2½ to 3 percent. But it’s very low, relative to history. So that holds down the whole yield curve. But that’s holding down the long end.

“And the second is, you know, whether QE [Quantitative Easing] in the U.S., or QE in Europe, or QE in Japan – globally central banks have taken enormous – taken – you know, made enormous efforts to provide liquidity and buy longer-term assets in the markets. And there’s no question that’s had an effect on long-term yields and pushed down long-term yields.”

We would have to quibble with Williams on one key point. When he says “history is probably not telling us a lot about the current situation,” we think he’s dead wrong. What history is telling us is that the downturn in 2001 was heavily impacted by bogus dot.com and tech stocks blowing a $4 trillion hole in the stock market after Wall Street analysts intentionally lied to the investing public about the companies’ prospects as they called the companies “dogs” and “crap” in internal emails. The 2008-2009 economic crash was solely caused by more corruption on Wall Street: hiding losses off the balance sheet; selling subprime debt products which the major Wall Street banks knew from internal reports were likely to blow up; creating a housing bubble by pumping money into subprime mortgage lenders because of the huge commissions that could be reaped by issuing toxic debt to pensions funds, institutional investors and gullible banks around the world.

What history is telling us today is that no material reform has happened on Wall Street to give us any comfort that its serial corruption will not play a major role in the next recession. The Fed and the public will ignore this at their peril.

Our advice is to not only keep an eye out for an inverting yield curve but to also watch the closing prices of big Wall Street bank stocks like JPMorgan Chase, Citigroup, Bank of America, Goldman Sachs and Morgan Stanley. When these stocks consistently lose more than the broader market averages (like the S&P 500 Index) and we also have an inverted yield curve, all bets are off for a soft landing.

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