The Yield Curve (Not the Sky) is Falling

September 25, 2018

  • The U.S. Treasury yield curve has been flattening — which increases the likelihood of a yield-curve inversion (when short-term interest rates are higher than longer-term interest rates).
  • Investors may be concerned because yield-curve inversions have historically been accurate predictors of impending economic recession.
  • Even if the curve does invert, we don’t believe that it will lead to an immediate market decline.

The U.S. Treasury bond yield curve — represented in graphs as a line that shows the relationship between interest rates and maturities of Treasury securities — has recently flattened.

This has caught the attention of investors and economists alike because a “normal” yield curve is positively sloped — that is, it moves in an upward direction from the shortest bond maturities (on the left end of the graph) to the longest bond maturities (on the right end of the graph). But in rare instances, short-term bond yields rise while long-term yields fall or rise more slowly than short-term rates, causing the yield curve to invert.

Normal vs.Inverted U.S. Treasury Yield Curves

curve

Source: SEI

As illustrated below, inversions have preceded each of the last five U.S. economic recessions by 10 to 34 months. Considering the recently-flattening yield curve, this data may worry market participants. However, even if the curve does ultimately invert, we don’t necessarily believe that it will guarantee an impending market decline.

Yield-Curve Inversions Preceding Recessions

flatten

Source: SEI

No one knows for sure when (or if) the flattening yield curve will invert, but the potential for inversion has been growing due to the interest-rate outlook for the next eighteen months. The Federal Reserve (Fed) has forecasted two remaining interest-rate hikes in 2018 and three potential hikes in 2019. The federal funds rate could hit a range as high as 3% to 3.25% by the end of 2019 if these anticipated rate hikes come to fruition, which could push the 2-year Treasury yield above the 10-year Treasury yield.1

This Time May Be (A Little) Different

In the last decade, the Fed has engaged in a massive asset-buying program (known as quantitative easing) that has caused long-term bond yields to rise more slowly than short-term bond yields. As a result, investors have received lower yields in exchange for the risk of holding bonds over a longer period of time.

According to the Fed, its asset buying has reduced 10-year Treasury yields by as much as 135 basis points (one basis point, or bps, equals one hundredth of one percent). This suggests that some flattening of the yield curve is a result of central-bank demand for longer-dated bonds — which could mean that a recession may not be as imminent as some believe.

Similar quantitative-easing measures in Europe and Japan may have further reduced 10-year Treasury yields, as foreign central banks’ asset-buying programs have funneled money into U.S. Treasurys. The unwinding of monetary stimulus in Japan and the eurozone may increase 10-year Treasury yields and steepen the yield curve.

Don’t Fear the Yield Curve

We don’t think the prospect of an inverted yield curve should be reason to remain on the sidelines of investing. Yes, the yield curve has been flattening for some time, but it has not inverted. While an inverted curve can be a strong recessionary signal, we view the currently flat-but-not-yet-inverted curve as a normal part of the market cycle.

According to the San Francisco Fed, every recession in the last 40 years was preceded by a yield-curve inversion; however, we do not necessarily expect all inversions to be associated with immediate market declines. After each of the last five inversions, for example, the S&P 500 Index gained 24.7% and the Bloomberg Barclays U.S. Aggregate Bond Index gained 7.2%, on average, from the point of inversion to the next S&P 500 Index peak return (Exhibit 3). While the time periods between inversion and S&P 500 Index peaks vary, history shows that investors who sell out of the markets immediately following a yield-curve inversion may miss out on gains.

Market Behavior

from Yield-Curve Inversion to S&P 500 Index Peak, 1978-2018

From Yield-Curve Inversion to S&P 500 Index Peak
  Returns from Inversion to Peak
2 to 10 year
yield curve
inversion dates
S&P 500
Index Peak
Months from
Inversion to S&P
Index Peak
S&P 500 Index* Bloomberg Barclays
U.S. Aggregate
Bond Index
8/18/1978 9/12/1978 0.8 2.7% 1.5%
9/12/1980 11/28/1980 2.6 16.2% -2.4%
12/13/1988 7/16/1990 19.3 37.7% 19.5%
5/26/1998 3/24/2000 22.3 38.3% 7.9%
1/31/2006 10/9/2007 20.5 28.4% 9.3%
Median 19.3 28.4% 7.9%
Mean 13.1 24.7% 7.2%

Source: LPL Research, FactSet, SEI

*Return is a cumulative return calculated monthly from the preceding month of a curve inversion through the month the S&P 500 Index peaks. Past performance is not a guarantee of future results.

Our View

Despite the track record of yield-curve inversions signaling recessions and significant economic slowdowns, we believe that other measures of financial stress should also be considered.

It’s also important to remember that recently-rising interest rates started their ascent from record-low levels. Inflation-adjusted (or real) interest rates remain quite low — a promising fact considering that policy rates (like the federal funds rate) tend to be several percentage points above the inflation rate by the time a recession begins.

We don’t think the Fed will be as hawkish as its forecasted policy rate implies. Chairman Jerome Powell’s recent remarks at the central bank’s annual meeting in Jackson Hole, WY, struck a slightly dovish tone, which we think points to a lower probability of inversion. We will continue to keep a close eye on the yield curve, but don’t see a need to panic.

1 The 2-year/10-year Treasury spread was chosen for simplicity’s sake; there are alternative yield-curve differentials (such as the 3-month/10-year) that are currently wider.

Legal Note

Important Information
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of SEI Funds.

There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments.

Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.

Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company (SEI). Neither SEI nor its subsidiaries is affiliated with your financial advisor.