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Written by: Scott Colyer | Advisor Asset Management
The U.S. Treasury yield curve has begun to steepen, and I don’t think that’s good news. But before I get into the nitty-gritty of why, there are a few things that you need to remember. 1) a yield curve is formed by charting Treasury yields from short to long maturity. Yield curves are normally tilted slightly positive since shorter-dated yields are typically lower than longer-term yields (which makes sense since one would generally expect to be paid more interest the longer one has committed to lending money to the borrower). 2) The chart below from Bank of America illustrates interest rates purporting to go back 5,000 years. One can clearly see the anomaly period of low rates we have been in over the past 15 or so years.
And 3) the Federal Reserve (Fed) has raised interest rates from zero — the lowest ever — to roughly 5.5%, prompted by a spate of high inflation that gripped the U.S. economy after the pandemic.
Now, let’s get back to today’s environment where shorter-maturity bonds are well above yields on longer-dated bonds ¾ primarily the product of the Fed forcing short-term borrowing rates higher and higher ¾ which has inverted the yield curve. An inverted curve is not “normal” for a healthy economy and usually coincides with a slowing economy. The chart below graphs the inversion of the 10-year Treasury note yield minus the 2-year Treasury note yield. Note that the inversion condition is now over a year old. That is rare in history as well.
Economic recessions have always been predated by an inversion in the Treasury yield curve; however, not every inverted yield curve is followed by a recession (although most are). The much-forecasted recession has not yet materialized as labor markets remain strong and real wages have begun to rise as well. This is primarily due to the sheer magnitude of stimulus that the Fed and Congress poured into the economy during the COVID-19 pandemic. While monetary stimulus conducted by the Fed has all but stopped, fiscal stimulus (government spending) has only slowed slightly.
Does the current steepening of the yield curve indicate that the recession scare is over, and that the U.S. economy is now in a fresh growth cycle?
Usually, a steepening curve occurs because the Fed is cutting short-term interest rates back below long-term rates — this is called a “bull steepener.” This usually happens after an economic trough and an abrupt slowing of the economy powerful enough to neutralize inflation pressures.
That condition is not what we are witnessing in today’s market. So far, the steepening has come from the long end of the yield curve moving higher versus the short end dropping — called a “bear steepener.” Bear steepeners are rare but have happened in history. They are referred to as “bear” because they are generally correlated to weakening economic activity. Long-term interest rates rising can cause difficulty for those companies who are cash strapped or experiencing a challenging employment environment. Just because we have had a couple weeks of “bear” steepening doesn’t mean the yield curve will return to a normal, gently sloped, positive curve. We will have to observe the situation and comment on it as it moves forward.
Chris Verrone, technical analyst at Strategas, notes that it is likely that the long maturity part of the U.S. Treasury yield curve is on the cusp of breaking out to higher yields. See chart below. He notes that if yields break about 4.34% on the 10-year Treasury and 4.42% on the 30-year Treasury we will be likely to see much higher yields in our future. Higher yields are not conducive to economic growth or margin expansion. As the cost of money continues to rise, profits generally suffer, and consumers suffer, which is what we are seeing at this point. This condition is rare, but we are seeing it globally in developed economies.
The bottom line here is that if rates on the long end continue to rise, it will un-invert the yield curve…but not in a good way.
Long-dated bond prices will likely suffer as well as long-duration assets, such as equities; economic health generally deteriorates, and the environment is more apt to see a recession than the beginning of a new bull market.
Remember, on average, equity markets don’t bottom until after the Fed has ceased raising interest rates. They have publicly reiterated that they are not done raising interest rates. Equity markets, on average, bottom around 195 days AFTER the Fed’s first interest rate cut. See chart below. We don’t expect that until next year. This gives us very little confidence in the narrative that is currently being put forth that there will be either no landing or a soft landing for the economy this time. The question, it seems, is if the answer is more likely that we will see an economic slowing, which is what the Fed has set out to do all along.
Source – Strategas
Our conclusion is that we are likely in a longer business cycle than normal because of the record-setting stimulus distributed in the economy during and after the pandemic. The economy and jobs have been good but not at normal economic cycle strength. We believe that higher interest rates for longer will be needed to fight inflation, which typically shows up in waves. We are between waves now, but that doesn’t mean we can celebrate victory. Higher interest rates will eventually slow the consumer, industry and the economy. We continue to believe that a recession or significant slowing is in the future for the U.S. economy.
The “bear steepener” is just one more indication of that event forthcoming.
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