Yield Curve

It would be a mistake to ignore (as most pundits will) this important forecasting tool until the next time it threatens to invert. The level and direction of the yield curve provide helpful information throughout the entire economic cycle.

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There has been chatter about the Fed implementing the so-called Yield Curve Control (YCC). Although the latest FOMC minutes suggest that YCC is not on the agenda for now, we believe the chance of YCC is probably much higher than the market currently anticipates.

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As the coronavirus materially increases the odds of a recession, some important parts of the U.S. yield curve (10Y-3M; 5Y-2Y) double-dipped into inversion. The two prior episodes occurred in late 1989 and mid-2006 and, in both cases, a recession followed within 18 months.

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We can’t count the number of times in the last week we’ve heard analysts worry about “what the Fed might know that we don’t.” In the words of John McEnroe, “You cannot be serious!”

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A way to gain perspective on the present is by trying to view it from the future. Ask yourself, “What are the signs of impending decline, now ignored by investors, that will one day be memorialized by the same investors as the most obvious in retrospect?”   

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This year’s upswing in money-supply growth has been one of many factors that’s prevented our economic work from triggering a recession warning. Following a two-year decline, year-over-year growth in M2 bottomed near 3% late in 2018 and has trended upward all year, reaching 6.7% in the latest week (Chart 1).

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The U.S. yield curve inversion has lasted long enough that even a few economic optimists now concede it will ultimately prove significant.

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The yield curve’s ten-month moving average inverted in September, hence the yield curve inversion can no longer be dismissed as transitory; the Boom/Bust Indicator remains below its descending 10-month moving average, confirming economic weakness predicted by the yield curve; and, the “Present Situation” component of September’s Consumer Confidence survey slipped below its 10-month moving average for the third time in 2019.

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We always do our own work and draw our own conclusions. Lately, though, we’ve wondered what the late “Monetary Marty” Zweig might say about the stock market’s current liquidity backdrop.

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Over a 12-month horizon, we now believe a U.S. recession is very likely, but aren’t confident enough to make the call when the forecast window is cut in half. Second-half stock returns could be decent if the business-cycle peak is still a year away. Then again, there’s peril in waiting for “too much” confirmation of recession.

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While the 10Y-3M curve inversion does warrant extra attention, movements in other parts of the curve also need to be taken into consideration.

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Last month, we observed that crude oil was the only item propping up broad-based commodity indexes, and that something was bound to give with the U.S. dollar pushing to new highs.

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Signs of spring are popping up everywhere in the Financials sector. S&P Financials was easily the top- performing sector in April and several sub-industries have been bubbling higher in our Group Selection discipline.

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Some recent headlines are word-for-word regurgitations of those published in response to the early-2006 yield curve inversion. In that case, the naysayers were temporarily correct, as both the U.S. economy and stock market pushed higher for another year and a half before rolling over.

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While the celebration over Jerome Powell’s “Christmas Capitulation” lingered throughout February, we’re still awaiting signs the capitulation consisted of anything more than words.

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While the number of recession forecasts is on the rise, there’s a general reluctance among economists to project a downturn in the absence of a yield curve inversion.

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The December employment report temporarily eased fears of a severe U.S. slowdown. That’s a mystery to us.

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We’ve sometimes called the yield curve our “favorite economist,” so we were amused when some enthusiastic data miner in the Treasury market tried to slip us a cheap imitation in late November.

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It’s been amusing to watch the narrative surrounding Fed policy evolve as the market has rallied.

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The increasingly greater attention given to the yield curve by equity investors has prompted us to come up with an equity basket that can track the movement of the yield curve. Overall, it does a reasonably good job of capturing the major moves.

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