Read the weekly bond market commentary from Drew O’Neil
August 6, 2018
A popular topic in the financial press recently has been the shape of the yield curve. More specifically, the recent trend of a flattening yield curve and the debate over whether or not it will invert (short-term yields higher than long-term yields) and if it does invert, whether or not it is a signal that we are heading for a recession. Many are arguing that if the yield curve does invert, the US economy will enter a recession based on the logic that the last few times the curve inverted, we entered a recession. Those on the other side of the argument are pointing out that we are in an unprecedented yield curve environment given the enormous amount of global quantitative easing experienced over the past 10 years, thus creating and “artificially” flat yield curve that can’t be compared to previous situations.
I am not going to debate this today, but I would like to point out an alternative recession indicator that was highlighted in a paper (read the full piece here) that was recently published by the Federal Reserve, in order to give another point of view on the topic. The metric that the paper focuses on is the spread between the three month T-Bill and the market implied forward rate 6 quarters in the future of the three month T-Bill. Simplified, it is the difference between the current three month Treasury and where the market expects the three month Treasury to be 18 months from now. The idea is that this is a good indicator of what the market expects the Fed to do with monetary policy for the next year and a half. As this spread goes negative (current three month rate is higher than the market thinks it will be in the future), it essentially means that the market expects the Fed to begin “easing” (lowering rates) soon, as the Fed does when the economy starts sputtering and needs a boost (i.e. a recession). Focusing in on just the short end of the yield curve and its corresponding futures, in theory, will eliminate some of the “noise” present in the 2 to 10 year spread.
This forward spread model essentially incorporates all available information that the market has as far as predicting which direction the economy is heading. Looking at the chart below, which plots both the traditional 2 to 10 year spread (blue line) as well as the 6-quarter forward spread (red line) discussed above, shows how both of these indicators have behaved over the past 50 years. The forward spread has historically shown steeper declines just prior to previous recessions than the traditional 2 to 10 year spread measure, indicating that it is a sharper predictor. They are highly correlated for most of this time period, although since the Great Recession, when the major quantitative easing by the central banks began, the lines start to diverge.
Since late 2015, when the Fed started raising short-term rates, the blue line has taken a fairly steady path towards inversion territory (below zero). Looking at the red line, we see that it has displayed much more of a sideways movement. Assuming an inverted yield curve is the signal for a recession, the 2-10 year methodology indicates that we have been steadily heading towards a recession since 2015, while the forward spread indicator has been moving fairly parallel. Another point to note in this graph is that these two lines are currently at roughly the same spot, so they are indicating the same likelihood of a near-term recession, with the main difference being the trend of each respective line/indicator.
Correlation does not indicate causation; these metrics may or may not be a signal for a coming recession. The point is to be aware of some of the outside influences that may be affecting the traditional recession indicator often discussed by the financial media, and consider that there are alternative viewpoints.
So what is the take away from this? The future is unknown and whether we are going to enter a recession at some point in the near future is anyone’s guess and is biased by whatever indicator they trust. Take this opportunity to prepare your portfolio for whatever might be coming our way. That means making sure that your growth assets are appropriately allocated to growth products and your capital preservation assets are appropriately allocated to capital preserving products.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.