Keep Calm and Stop Worrying About 'Bondmaggedon'
The flattening of the yield curve is unnerving some investors because of its history of presaging recessions. But a narrow curve is hardly an efficient or timely signal, especially when it hasn’t yet inverted. Many factors account for the flattening of the curve, which could even offset the headwinds introduced by Federal Reserve interest-rate hikes by providing cheap, long-term financing. Economic expansion is likely to continue somewhat faster than desired by the Fed, and both short- and long-term interest rates could rise for the foreseeable future.
A flattening or inversion of the Treasury yield curve has almost always occurred prior to a recession. But the advance warning it provides has varied sufficiently that an inversion can only be considered a weak signal, at best, of an impending economic decline, as suggested by the table below. For example, the two- to 10-year yield spread flattened from more than 250 basis points to a mere 22 basis points in 1994 with no recession before widening out. In June 1998, it inverted to negative two basis points without a recession. It inverted again in February 2000 to minus 9 basis points, and the recession didn’t arrive until 13 months later. Similarly, the curve inverted to negative 10 basis points in February 2006, but the recession didn’t arrive for another 22 months. Apparently, even inversions do not necessarily or quickly lead to recession.
Now, the signal provided by the flatter yield curve is even more garbled than usual. The U.S. expansion is far ahead of growth in Europe and Japan, and the European Central Bank and the Bank of Japan are still actively engaged in quantitative easing to support stronger rebounds. Some of that excess liquidity is flowing into the U.S. market and distorting yields. It is very cheap to borrow overseas and invest at much higher yields in the U.S., if you are willing to take the foreign-exchange risk. Some of the rate comparisons are simply shocking. Who would have imagined that 10-year Italian bonds, at 1.82 percent, would yield so much less than 10-year Treasuries? So it is hardly surprising that international capital flows are pushing down longer-term U.S. yields. However, this promotes stronger U.S. economic growth instead of predicting weakness.
Inflows of foreign capital help U.S. companies borrow at lower rates than would otherwise be available. These inflows are counteracting the headwinds introduced by the Fed’s rate hikes. Not surprisingly, corporate treasurers appreciate the opportunity provided by the market, and they keep borrowing heavily, either to finance investment or to buy back stock. So the flattening of the yield curve, though unintentionally, also contributes to the stock market’s resiliency in the face of widespread doubt that equities can sustain “record” levels.
More crucial than the shape of the yield curve is the absolute level of rates relative to inflation, the so-called real interest rate or the real cost of capital. Real rates are not just low historically, they are unsustainably low. After taxes, an investor in 10-year Treasuries earns about 1.6 percent, materially less than the Fed’s 2 percent inflation target. The investing public is effectively making an annual donation to the U.S. government locked in for 10 years! Surely, that does not represent any kind of sustainable equilibrium.
An investor in corporate bonds is faring only slightly better. With 10-year A-rated paper yielding around 3 percent, assuming investors are in the 39.6 percent federal tax bracket and ignoring the Medicare tax surcharge and state income taxes, the after-tax yield of 1.81 percent isn’t much better and remains well below the Fed’s 2 percent inflation objective. Many companies issue debt at lower yields than they pay common shareholders, so it is financially attractive for them to buy back stocks. These repurchases have been shrinking the supply of shares outstanding for the past several years. If the yield curve flattens further, such debt-financed stock buybacks may intensify further. And the flattening should contribute to supporting economic growth by keeping down the equity cost of capital, reinforcing the economic expansion.
Rising long-term interest rates can't be a headwind to economic growth at the same time that falling yields are supposed to hurt growth. Any Fed rate hikes that cause long yields to fall and the curve to invert are more likely to alter borrowing terms, but not deter capital spending.
The Fed welcomes the ongoing expansion of the economy and the corresponding decline in the unemployment rate, but only to a point. This pressure cooker cannot keep going without potentially unleashing serious unfavorable consequences. As labor becomes scarcer, supply and demand will drive up labor costs and inflation. With all of the reasons that have been provided by people to “explain” that inflation will remain dormant, no one suggests that supply-and-demand dynamics have been repealed. The reasons given have simply distracted investors from the systematically growing scarcity of labor. It isn’t a problem until it is.
I am quite certain that most senior officials at the Fed understand this, which is precisely why they are methodically raising rates, even without sizable increases in inflation. Their worst nightmare is a sharp rise in inflation, which would signal that the Fed has been insufficiently preemptive in its policy action. Investors would also quickly understand that the yields on their bonds are too low and bond prices will plummet and the curve will suddenly steepen. This is the basis for the “Bondmageddon” thesis espoused in some circles. And the risk to the economy of a downturn would then become very real. Be concerned about the possibility of a sudden steepening of the yield curve, not of the gradual flattening that has taken place.
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