So what if the yield curve inverts?
The spread between short- and long-term interest rates continues to shrink — the difference between 2- and 10-year Treasury bonds was just 21 basis points on Sept. 14 — but equity investors are shrugging off the bearish signal from the bond market.
When short-term bonds pay more than long-term ones, it's usually a signal that economic growth is peaking and that a recession is on the horizon. It does not, however, mean a downturn is necessarily around the corner or that stocks are headed for a crash.
"An inverted yield curve doesn't cause a recession," said Matt Toms, chief investment officer for Voya Financial. "People get confused about the causality on that front."
It does, however, provide a strong reminder that economic cycles and bull markets don't last forever. Toms, for one, thinks the Federal Reserve Bank will pause on its path back to "normal" monetary policy to avoid an inversion of the curve. "Chairman Powell is a markets person," said Toms. "We think the Fed will stop pushing and the curve should begin to steepen by year-end."
Bob Miller, head of the U.S. multisector fixed-income team at BlackRock, also thinks the Fed will try to avoid a curve inversion. "It's possible that the yield curve inverts, but I think it's unlikely," he said. "We think the Fed will be sensitive to that possibility, and if the 10-year Treasury yield fails to rally, the Fed will signal that quarterly rate hikes are too aggressive."
The flattening yield curve may not be as good a leading indicator of the economy as it has been in the past, anyway. While economists and market analysts never like the "this time is different" argument, the post-financial crisis environment is clearly unlike previous economic cycles.
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"The curve is suggesting that long-term growth will slow, but it is sending a weaker signal about the economy than it has in the past," said Jim Caron, a portfolio manager and member of the global fixed-income team at Morgan Stanley.
For one thing, the $4-trillion-plus portfolio of long-term bonds the Fed is holding is still depressing long-term bond yields. Quantitative easing was specifically intended to reduce the term premium for longer maturity bonds in order to support the economy post-financial crisis, and it has succeeded. Last year the Fed estimated that the large-scale asset purchases (LSAPs) and maturity extension program (MEP) it instituted between 2008 and 2014 reduced the term premium on the 10-Treasury bond by about 100 basis points.
With the Fed now paring back its portfolio — by reinvesting less of the proceeds of maturing bonds — the premium reduction has likely fallen to about 40 basis points, according to Caron. "If you adjust for quantitative easing and its effect on the term premium, things start to look more normal," he said.
Several other factors beyond economic and inflation expectations are also depressing long-term interest rates. The biggest may be the divergence of global central bank policies.
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While the Fed is pursuing a path toward normalization, other central banks — notably the European Central Bank and the Bank of Japan — continue to support their economies with much lower interest rates and/or bond-buying programs. The difference between the 10-year Treasury bond and the 10-year German bund is still more than 2.5 percent. While hedging costs have risen for foreign investors, the large rate differential between the United States and other developed markets is a magnet for foreign capital.
"The low level of European and Japanese interest rates is helping to keep the yield curve flatter," said Toms. The news of even a very modest change in policy stance by the Bank of Japan in July steepened the U.S. yield curve by 9 basis points because of expected lower demand for Treasurys from Japanese investors, Toms noted. Miller suggested that ECB and BOJ policies are holding down long rates in the United States by between 40 and 80 basis points. Foreign demand for higher U.S. bond returns will likely continue to support long-term Treasury prices and hold down yields.
Another factor driving demand for long-term Treasury bonds this year is President Donald Trump's tax bill. It reduces the statutory corporate tax rate to 21 percent, from 35 percent, and presents a huge tax-savings opportunity for companies with unfunded pension liabilities.
Contributions to defined benefit pension plans are fully tax deductible for companies, and they had until Sept. 15 to claim the deduction (at the higher tax rate) on their 2017 tax returns. General Electric, for example, made a $6 billion contribution to its plan earlier this year, and consultants estimate that U.S. companies, as a whole, have contributed in the range of $100 billion to their plans. Much of those contributions have been invested in long-term bonds to match pensions' long-tailed liabilities.
"An inverted yield curve doesn't cause a recession. People get confused about the causality on that front." -Matt Toms, chief investment officer for Voya Financial
"It was a pretty substantial tax-savings opportunity, and the window closed on Sept. 15," said Michael Tiedemann, head of Tiedemann Advisors. "It's been driving demand for 10-year bonds."
The passage of that deadline may be one factor behind the recent fall in Treasury bond prices. The 10-year yield — which moves inversely to bond prices — has risen to 3.08 percent as of Sept. 19.
Whether interest rates will continue higher from here and how that might impact the economy is a tough call to make in this environment, said BlackRock's Miller. The four major government policy levers in the economy — fiscal, monetary, regulatory and trade policy — all have reversed directions under Trump.
"In the last year and a half the policy mix has changed dramatically," said Miller. "Each policy lever has a different lag in its effects, and it's very hard to fathom the net impact of all the changes."
It also makes it hard to handicap the odds of a yield-curve inversion and whether that matters as much in this economic cycle.
