Yield Curve Hysteria
I’m not going to lie. It was a rough week for the markets. A bit of panic took hold as investors rushed into “safe” investments such as U.S. Treasuries, pushing interest rates lower than they have been in a long time. Some parts of the yield curve “inverted” while the long-end went below 2% for the first time ever. These are not normal times and the market is overreacting in fast and impulsive ways. The 800-pt drop in the Dow Jones Industrial Average was an aberration sparked by fear and perpetuated by the media.
Note: A yield curve inversion is simply when short-term bonds have higher yields than do longer-dated bonds. It is normal to see an upward sloping yield curve indicating that the further out the maturity, the higher the rate of return. You see this in CD rates as well. The metric that most analysts look at is the 2yr and 10yr Treasuries. At the moment, a 2yr treasury is yielding around 1.47%. Those looking to buy a 10yr treasury will receive about the same. In a nutshell, investors aren’t being rewarded for the additional risk of buying a bond with a maturity farther out into the future.
To be fair, protracted uncertainty on trade is having some impact on business sentiment. However, the U.S. economy is holding up well, and now stands to benefit from a more dovish Federal Reserve. China has shown a bit of weakness, but not a sharp slowdown. The weakness in Europe is more pronounced, notably in Germany as we’ve seen with recent gross domestic product data, but by no means a collapse.
The US economy continues to create jobs at a robust clip, even with the unemployment rate already at a 50-year low. Tightness in the labor market is beginning to show up in higher wages, which coupled with low inflation, allows for more disposable income for consumers. Household consumption powers the economy, and the household saving rate as of June this year is at a very healthy 8.1%.
In short: the economic data shows no evidence that the United States is approaching a recession. The markets and the Fed seem to be looking at each other, feeding each other’s fears, and completely ignoring what’s going on in the real economy.
Part of the hysteria is that when the yield curve inverts, it has been followed by a recession. You’re probably thinking, but he said there’s nothing to worry about? Well, yes and no. The piece of data that isn’t widely reported is that it typically takes anywhere from twelve to eighteen months for the recession to happen. I don’t have a crystal ball, but the probability of a recession happening soon is very slim. Economists put a 30% chance of a recession happening in the next twelve months. In all likelihood, if we have a recession, it won’t occur until sometime in 2021.
In closing, let me throw one more curveball your way. An inverted yield curve is one thing, but what about negative interest rates? Think it can’t happen? It is already happening in a number of developed countries around the world including Germany, France, Belgium, Switzerland, and Japan. While not discussed much, I believe these negative interest rates abroad are helping to drive foreign investors, institutions, pensions, and banks to buy U.S. treasuries, thereby further pushing rates lower. However, this week I came across another story that really did leave me scratching my head. A Danish bank has started offering mortgages with a negative interest rate. Denmark’s Jyske Bank is now offering a 10-year fixed-rate mortgage at negative 0.50%. Additionally, Finland-based Nordea Bank announced it will offer a 20-year fixed-rate mortgage in Denmark that charges no interest and is looking to extend that to the traditional 30-year mortgage. To be clear, with a negative interest rate, the borrow ends up paying back less than the amount they borrowed. While I can’t see that happening in the United States, it is something to ponder as you look at your mortgage statement. Now you know.
Bruce Mason, MBA