If you were to compile a list of the most effective recession predictors, the term spread, or the difference between short and long-term interest rates would likely be at the top of that list.
This is because the term spread (also known as the slope of the yield curve) has an uncanny ability to predict economic slowdowns. Over the past 60 years, every recession we’ve experienced has been preceded by an inverted yield curve. Not only that, a negative term spread has ALWAYS been followed by an economic slowdown – even if it did not result in an official recession.
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The term spread is generally calculated as the difference in yield between the 10-year Treasury and either the three-month Treasury bill, one-year Treasury note, or the two-year Treasury note. Regardless of which measure you use, the results are strikingly similar.
In the chart below, the blue line represents the term spread as defined by the difference between the 10-year note yield and the one-year note yield. As you can see, the term spread crossed the zero threshold (indicating a negative slope) prior to each of the last nine recessions.
It’s important to note that the delay between the yield curve turning negative and the beginning of each subsequent recession has ranged from 6 to 24 months. This indicator has provided ample warning to those investors who have taken the time to listen to it.
I should also mention that while this data is based on the US economy, the same predictive power is seen with a number of other advanced economies. So it’s not something unique to the US that gives the yield curve its predictive power.
What’s more, since the stock market itself is also a discounting mechanism – attempting to anticipate a deterioration in corporate profits (which typically comes alongside a recession) – the yield curve actually makes for a decent equity timing indicator.
I created the odd-looking composite chart below to try to highlight this. In the top chart, we have the S&P 500, and in the lower chart, we have the slope of the yield curve, as evidenced by the spread in yield between the 10-year and two-year notes.
The orange columns are drawn to reference when the yield curve turns negative, and as you can see, these periods tend to correspond with short-term peaks in the S&P 500.
I think we can all agree that this is not the most precise timing indicator, but if you take a look at the orange bars in the top chart, you can see that in all cases, the stock market was lower (in some cases substantially lower) one year out. Based on this, I think it’s fair to say that the term spread can play a role in managing equity portfolios. When the spread goes to zero, it’s time to light up those stock positions.
Now that we understand that there is value in the term spread, let’s examine it in more detail. The first logical question is – what causes the term spread to collapse or turn negative?
Here is the San Francisco Federal Reserve Bank’s explanation:
While historical circumstances differed for these episodes, the patterns of past yield-curve inversions were remarkably similar: The decline in the term spread was generally driven by a pronounced increase in short-term interest rates. Long-term rates, on the other hand, typically moved much more gradually and either increased slightly over those periods or even declined.
This is a very telling statement if you read between the lines. Effectively, what the Fed is saying is, “Yep, it was us … we caused all those inverted yield curves by raising short-term interest rates in the face of stagnating or declining long-term yields.”
Wow.
If you want some graphical evidence of this, take a look at the following chart. Here, the red line represents the 10-year Treasury yield, and the blue line represents the effective federal funds rate (the rate that the Fed controls).
Each time the blue line rises, it represents rate hikes on behalf of the Federal Reserve. I’ve included black stars in the chart to highlight each time the blue line crosses above the red line – indicating an inverted yield curve.
As you can see, in just about every case here, the inverted yield curve was caused by short-term rates moving higher (due to the Federal Reserve), NOT long-term rates moving lower.
This is important because I would argue that the long end of the yield curve – the part controlled by market forces – is actually a good indicator of future economic growth. This is because long-term rates self-adjust based on economic fundamentals, as evidenced below. (Note – for a more comprehensive description of this chart, please see my previous article The Illusion of Power.)
So basically, the way I see it, when the Fed raises short-term rates above the level of the 10-year note, what they’re really doing is pushing short-term rates above what economic fundamentals suggest is sustainable. The result? Recession … or at least an economic slowdown.
Okay, now here’s where it gets fun.
Due to a strong labor market and an itch to get as far away from the zero bound as possible (thus restocking rate-cutting ammunition), the Fed has embarked on a rate hiking path. But at the same time, inflation, which is a primary driver of long-term rates (see chart above), has remained stubbornly low, as has real GDP growth. These economic fundamentals suggest the economy is not robust enough to handle significantly higher interest rates.
And yet, here (below) is the Fed’s projection of future short-term interest rates, also known as the “dot plot.” In it, we can see where individual FOMC members expect the federal funds rate to be over the next couple of years. Right off the bat, you should notice that some Fed members project short-term rates to exceed 3% as soon as 2019.
With the 10-year note currently yielding 2.84%, this presents an unnerving situation. Should the 10-year note remain near its current level, this means we could see an inverted yield curve as soon as next year.
But as I mentioned (and quoted) above, the Federal Reserve seems to understand, at least to some degree, that it is THEY who habitually raise short-term rates above what long-term rates suggest are sustainable. Therefore, is it possible they’ve learned their lesson?
I doubt it. The Fed had all of this evidence back in 2006/2007, and they still decided to embark on arguably one of the most aggressive rate hiking cycles in history. They hadn’t learned their lesson then, so what makes us think they have now?
Of course, we do have a new Fed chair, one who has less econometric expertise than most previous Fed chairs, so there’s a chance that “this time is different.” But let’s plan to err on the side of caution, shall we?
Here’s how I see this all playing out:
Scenario 1 – The US economy continues to improve. Accelerating real GDP growth along with rising inflation push long-term rates higher, which gives the Fed ample room to continue along their dot-plot path without collapsing the term spread to zero. Hooray.
Scenario 2 – The US economy continues to sputter along with real GDP growth and inflation remaining close to their current levels. The yield on the 10-year note also remains near current levels and the Fed, committing the same mistake it has made all through history, continues to raise rates, overtightening financial conditions and pushing the economy into recession. Bummer.
Scenario 3 – Same as scenario 2, except that the Fed recognizes that long-term rates are a reflection of economic fundamentals, and chooses to keep the federal funds rate in line with what the market suggests is sustainable (it maintains a positive term spread). Hooray.
Scenario 4 – The US economy begins to deteriorate, both real GDP and inflation fall, and as a result, long-term interest rates fall. The Fed is forced to walk back its plan for rate hikes, and either holds rates steady or begins to reduce them. Bummer.
Of course there are other scenarios that could come to pass, but I think these scenarios convey the point I’d like to make, which is this: the sustainability of this economic expansion (and thus bull market) either depends on real GDP growth and inflation rising and outpacing the current projected path of rate hikes OR the Fed NOT following through on all of its planned rate increases.
Absent one of these conditions, I think we can answer the question posed by the title of this article in this way: If and when the Fed does close the term spread, we significantly lighten up our stock holdings (and perhaps even transition the bulk of our portfolios to bonds) and we buckle down and prepare for a recession.
Things don’t necessarily have to work out the same way they have in the past, but investing is all about probabilities, and an inverted yield curve has an exceptional predictive track record.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.
