Markets and Economy
Reassessing the Inverted Yield Curve
At first glance, tumbling bond yields seem to imply economic pessimism among investors. However, rather than expecting an imminent downturn, bond investors are likely responding to distortion from quantitative easing (QE) abroad, which may hold relatively little significance for the American economy.
- Treasury yields have fallen steadily through 2019, with the 10-year yield shedding almost 140 basis points since last November.
- The yield curve is growing more inverted, but the inversion’s significance is unclear. Most explanations for declining yields are unsatisfying.
- Quantitative easing abroad may be depressing yields and amplifying shifts in investor sentiment.
There is no single convincing explanation for Treasury yields’ steady decline over the last year. The most commonly cited causes—anxiety over trade tensions and uncertainty about future GDP growth—seem unlikely to have caused yields to fall more than 100 basis points in the past nine months. There is little doubt the Federal Reserve will achieve its 2 percent inflation target in the long run, yet the 10-year Treasury yield is currently running below that target, showing no real return.
At first glance, tumbling yields seem to imply deep pessimism among bond investors. Yet other indicators suggest reason for economic optimism: historically low layoffs are demonstrating a low level of distress in the business world and relatively narrow yield spreads are a sign that corporate debt is on solid footing. Rather than expecting an imminent downturn, bond investors are likely responding to the distortion from quantitative easing (QE) abroad, which is pushing yields down and amplifying mild shifts in sentiment.
1) Trade tensions: It’s easy to imagine a worst-case scenario in which trade tensions with China continue to escalate and rounds of reciprocal tariffs hamstring the economy. If investors believed the trade conflict was about to trigger a recession, they might respond by seeking safety in Treasury securities, no matter how low yields sink.
But that concern is purely hypothetical. The tariffs levied on Chinese imports so far amount to a tax of only 0.15 percent of GDP, less than 1 percent of all federal taxes. Furthermore, the impact of last year’s tariffs was almost entirely offset by the 11.5 percent devaluation of the Chinese yuan, which left prices for US consumers largely unaffected while the stock market’s valuation reflected high optimism.
Trade tensions have created uncertainty for businesses that rely on overseas supply chains, but businesses are constantly managing a vast array of future risks. It seems unlikely that the trade conflict is depressing Treasury yields while leaving corporate bottom lines largely unscathed.
2) Secular slowdown: As the top of the business cycle arrives, growth is slowing to a sustainable rate. A tighter labor market means businesses will no longer be able to expand at an above-trend pace. The aging US population is also causing workforce growth to slow, limiting the economy’s potential for expansion.
Lower expectations for future GDP growth would dampen Treasury yields, as long-term interest rates tend to naturally follow the pace of economic expansion. However, the labor market’s tightening has occurred gradually, and the slowdown in workforce growth has been playing out for over a decade. Surely bond investors have not been caught off-guard—this modest secular slowdown was unfolding long before yields began to fall.
3) Tamer inflation: Inflationary pressure has been modest, despite the tightening labor market and historically low interest rates. If investors expect inflation to remain soft, then yields would be expected to fall.
But inflation is nearing the Fed’s official target, and the most reliable measure of price movements is closing in on 2 percent. It’s unlikely that investors believe inflation will undershoot the Fed’s official target by enough to justify a 100 basis point decline in yields.
4) Political pressure: A recent editorial by four former Fed Chairs condemned the political pressure that threatens the independence of the Federal Open Market Committee (FOMC). July’s quarter-point rate cut sparked fears that the FOMC is capitulating to political pressure, and futures markets are pricing in a higher likelihood of additional cuts this year.
Last month’s rate cut, however, was made from a neutral stance, with inflation running slightly below target. The Fed is not so beholden to external pressure that it would risk damaging inflation in order to achieve short-term political gains. It’s unlikely that policymakers would consider cutting rates by anywhere close to a full percentage point unless conditions shift dramatically.
QE Distortion From Abroad
Across Europe and Japan, years of quantitative easing have pushed real returns deep into negative territory. Investors seeking government debt with higher returns than these Treasury securities would be forced to invest in bonds from nations with less-developed economies, like China, Mexico and Brazil.
Since the bond market is global, distortions in the Japanese and European bond markets are likely pushing down US Treasury yields, too. After the Fed decided to stop selling off excess reserves, strong international demand has been competing for a relatively limited supply of newly issued Treasury securities.
What Inverted Yields Mean
As long-term Treasury yields continue to fall, the yield curve is growing more inverted. In the past, when short-term interest rates climbed above the yield on long-term government debt, it was a sign that monetary policy had turned restrictive and a recession was looming.
The current situation, however, is quite different. Unlike in the past, when the Fed was deliberately tightening, the lower bound of the Fed’s target for short-term interest rates today rests only a quarter-point above its inflation target—hardly a restrictive monetary stance. And instead of being caused by a rapid climb in short-term interest rates as inflationary pressure mounted, the current inversion has been caused by a decline in long-term yields while inflation has remained tame.
It would be a mistake to assume the current inversion carries the same message as in the past. It could be a signal of shifting expectations around the future of interest rates, inflation and growth, or a sign that investors are nervous about trade disruptions. But it could also be the influence of unconventional monetary policies abroad on the US bond market. With few warning signs appearing in the broader economy, falling yields may not be delivering the message they used to.
Ultimately, it’s important to remember that bond investors are not confined to a single market. If falling Treasury yields truly reflected trouble on the horizon, then the bond market’s pessimism would be spilling over into equities valuations and corporate credit spreads. The distortions pushing Treasury yields downward may hold relatively little significance for the American economy.
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Jim Glassman, Head Economist, Commercial Banking
Jim Glassman, Head Economist, Commercial Banking
Jim Glassman is the Managing Director and Head Economist for Commercial Banking. From regulations and technology to globalization and consumer habits, Jim's insights are used by companies and industries to help them better understand the changing economy and its impact on their businesses.