The biggest financial news last week was further yield curve inversion in the aftermath of the Federal Open Market Committee (FOMC) meeting.
The FOMC meets approximately every 6 weeks to decide the monetary policy of the Federal Reserve. The main tools at their disposal include affecting short-term interest rates and growing or shrinking their balance sheet by buying or selling bonds (aka quantitative easing or tightening).
In the past few months, the FOMC has shifted to being more dovish, meaning a focus on flat/lower interest rates and an end to quantitative tightening later this year. They had originally intended to raise rates further, and continue quantitative tightening longer, but the stock market sell-off in the last quarter of 2018 as well as weakening economic data appear to have changed this in recent months.
Jerome Powell, chairman of the Federal Reserve, indicated last week during the FOMC public remarks that 2019 appears to be shaping up for slower growth than we saw in 2018:
“Data arriving since September suggest that growth is slowing somewhat more than expected. Financial conditions tightened considerably over the fourth quarter. While conditions have eased since then, they remain less supportive of growth than during most of 2018. Growth has slowed in some foreign economies, notably in Europe and China. While the U.S. economy showed little evidence of slowdown through the end of 2018, the limited data we have so far this year have been somewhat more mixed.”
-Jerome Powell, March 20th 2019
Usually, longer-term bonds give investors higher interest rates than shorter-term bonds. This is known as the “yield curve”- the chart of increasing interest rates as you look out over longer maturity profiles in treasury bonds.
During rare inversions, usually preceding an economic slowdown, short-term bonds instead have higher yields than longer-term bonds, so the yield curve visually flips upside down.
In the aftermath of the this week’s FOMC statement, long-term bond yields declined, as the bond market began pricing in a higher probability of an interest rate cut in the coming year. Now, 10-year treasury note yields at 2.44% are lower than 1-6 month treasury bills at 2.46-2.49%:
The longest 30-year bond still hasn’t inverted under the 3-month bill, and the 10-year note hasn’t inverted under the 2-year note. These are some of the closest-watched relationships.
However, the continued flattening and inversion of various points on the yield curve is worrisome to many investors. The Federal Reserve is easing monetary policy due to mixed data and potential economic weakness in the U.S. and around the world. Furthermore, when the yield curve inverts, it can result in bank lending slowing down significantly, as banks generally rely on the profits made from borrowing at lower short-term rates and lending at higher long-term rates. A lack of bank lending can cascade into some small businesses being unable to expand or operate due to insufficient capital.
The result now is that G Fund yields, which are based on the average of 5-year through 30-year treasury bonds, are potentially flattening out or even going lower this year compared to where they were in mid/late 2018.
Furthermore, a flattening yield curve is a bearish sign for the economy and stock market in general. This chart for example shows the historical difference between 10-year treasury yields and 2-year treasury yields, with recessions shaded in grey:
The difference (blue line) between these two bonds normally declines as an economic expansion progresses, and inverts (crosses below zero) an average of about 18 months before an expansion ends and a recession begins.
However, while the market takes this as a bearish sign, nothing is for certain. A common adage in the financial world is the quote from Mark Twain, “History doesn’t repeat itself but it often rhymes.” In other words, history is a guide to the future but by no means a precise map.