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US Economy

Grading the US Economy on the (Yield) Curve

By Elliott H. Gue, on Mar. 24, 2015

Newsletter writers and economic pundits love simplistic investment rules about interest rates and stocks, which perhaps explains the media’s obsession with extracting hints about the Federal Reserve’s future monetary policy from every offhand utterance Fed officials.

How many times over the past few years have pundits warned that you should sell utilities, master limited partnerships (MLP) and dividend-paying equities because the Fed looks ready to raise interest rates?

Rising interest rates are bad for stocks and really bad for dividend-paying groups, right?

Our job would be a lot easier if the market conformed to half-baked aphorisms. But in a messy, complex world, clinging to these nursery rhymes can cost you serious cash.

History Lesson

Consider that between June 2004 and June 2006, the Federal Reserve hiked the Fed funds rate a total of 17 times, ratcheting up the benchmark interest rate from a low of 1 percent to a high of 5.25 percent.

Over this two-year period, the S&P 500 gained 15.5 percent, a healthy 7.5 percent annualized. Meanwhile, the Philadelphia Utility Index—a widely-watched index comprising 20 prominent US electric utilities—surged 48.9 percent, besting the S&P 500’s total return by a 3-to-1 margin.

The Alerian MLP Index, which tracks 50 of the largest energy-focused MLPs, rewarded investors with an almost 39 percent total return over this two-year period.

And Fed tightening isn’t necessarily bad news for the bond market, either. From June 2004 to June 2006, the FINRA BLP Active High Yield Corporate Bond Index managed a total return of 15.6 percent—on par with the S&P 500.

High-yield, or junk bonds—debt issued by names with credit ratings below investment grade—tend to perform well when the economy strengthens and companies with shakier balance sheets earn solid profits.

However, even long-dated US Treasury securities performed well during the Fed’s 2004-06 tightening cycle. For example, iShares 20+ Year Treasury Bond (NYSE: TLT)—the most actively traded fund tracking the US government bond market—eked out a 10.5 percent return between June 2004 and June 2006. Investors should also remember that Treasury bonds are far less volatile than equities; this slightly inferior total return entailed less risk.

Bottom Line: The next time some pundit or talking head tells you to sell dividend-paying stocks because Fed is on the verge of hiking interest rates, run the other way.

How to Interpret Interest Rates

Rather than scrutinizing every word in the Federal Reserve’s latest statement, investors should pay attention to the slope of the yield curve, a graphical representation of the yields on Treasury bills and notes of various maturities.

(Click graph to enlarge.)US Teasury Yield curve

In the current environment, yields on US government bonds rise as maturities extend, resulting an upward-sloping curve.

One way to calculate this slope involves subtracting the yield on three-month Treasury bills (0.01 percent) from the yield on 10-year US government bonds (1.91 percent). This approach results in a slope of 1.90 percent.

Check out this graph tracking the yield curve’s slope on a monthly basis and pay particular attention to periods when the yield on short-term Treasury bills exceeds the current return on 10-year US government bonds.

(Click graph to enlarge.)Treasury Slope

An inverted yield curve often indicates that the US economy is headed for recession.

Here’s the logic.

The yield on three-month Treasury bills is heavily influenced by Fed policy, which is why some traders say that the central bank controls the “short end” of the yield curve.

For example, when the Fed hiked its benchmark rate from 1 percent to 5.25 percent between June 2004 and June 2006, the yield on three-month Treasury bills climbed from about 1.25 percent to more than 5 percent.

Market expectations exert more of an influence on the yields offered by longer-term bonds.

For example, when market participants expect US economic growth to accelerate and inflationary pressure to pick up, the yields on 10-year government bonds and other longer-dated issues tend to rise to compensate investors.

In recent years, yields on 10-year Treasury bonds have remained low because the US, like most developed economies, faces deflationary—not inflationary—pressures. A combination of weak wage growth and a lackluster recovery from the 2007-09 financial crisis and recession means that market participants expect inflation to remain tame.

The Federal Reserve’s quantitative easing (QE)—buying bonds—has also helped to lower the yield on 10- and 30-year Treasury securities. With this program, the central bank sought to combat deflation and boost inflation to its target rate of 2 percent.

An inverted yield curve suggests that the Federal Reserve has tightened monetary policy, resulting in relatively high short-term interest rates. At the same time, the market’s expectations for US economic growth and inflation remain low, compressing the yield on long-dated US Treasury bonds.

The yield curve usually inverts after the Fed has tightened monetary policy for an extended period and weak US economic data suggests that slower growth is on the horizon.

The US yield curve last inverted in summer 2006, on the heels of a two-year cycle of rate hikes. According to the National Bureau of Economic Research’s Business Cycle Dating Committee—the official arbiter of the US business cycle—the domestic economy entered recession in December 2007.

The yield curve also inverted in August 2000, about seven months before the US economy officially entered recession in March 2001. In fact, this simple indicator

In fact, this indicator has correctly forecast all the major US economic downturns since the early 1960s.

In contrast, the yield curve’s slope tends to be very steep near the beginning of major economic recoveries; the Fed usually cuts rates aggressively to stimulate growth, pushing down the yields on three-month Treasury bill. Meanwhile, as the recession approaches its conclusion, market participants start to price in an economic recovery, inflationary pressures and higher interest rates, boosting the yield on 10-year bonds.

The Yield Curve Today

What does the yield curve look like today? The Fed’s easy-money policies have kept the yield curve relatively steep since 2009, but this indicator started to flatten in early 2014.

(Click graph to enlarge.)
Short Term Yield Curve Slope

With the three-month yield hovering near zero percent, falling yields on 10-year US government bonds have driven this phenomenon.

The decline in the yield on 10-year Treasury bonds reflects the market’s expectations that inflationary pressures remain low and that the Fed’s monetary policy will remain accommodative until long after the US economic recovery has demonstrated its sustainability.

At this point, the yield curve’s slope is far from levels that would suggest the US is at risk of recession. The Federal Reserve Bank of Cleveland publishes a mathematical model based on this yield curve indicator that projects the probability of recession over the next 12 months. Currently, this model estimates the risk of recession at 4.12 percent.

What We’re Watching

The market is convinced, probably with good reason, that the Fed will hike interest rates at some point this year. After all, the central bank aims to start normalizing monetary policy at after years of unprecedented stimulus.

As the Fed raises rates, the yield on three-month Treasury bills will also climb. However, the yield on 10-year Treasury bonds has room to fall further or, at the very least, hold steady, as US economic growth appears to have slowed again. (See How to Spot a Bear Market and Fear, Greed and the Purchasing Managers Index.)

If this scenario plays out and short-term yields rise while long-term yields remain flat or fall, the yield curve’s slope will continue to decline.

Bottom Line: For investors, monitoring the yield curve is a lot more productive than trying to divine the timing of the Fed’s next move or investing based on mythical relationships between short-term interest rates and dividend-paying stocks.

I recently made A Free Video Report highlighting other warning signs on our radar screen and three simple steps you can take to protect your portfolio in the coming bear market.

Click here to see Elliott Gue’s 3 Warning Signs

3-warning-signs-red

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