The U.S. economy is showing more vigor – according to the Atlanta Fed model, leading indicators predict a 3.5 percent fourth-quarter growth. That’s remarkable following second- and third-quarter growth at or above 3 percent but for some analysts a flattening yield curve could harken another recession.
Economists prefer to measure the steepness of the yield curve by taking the difference between the rates on the 10-year Treasury and the 30-day T-bill. Every recession since the 1950s has been preceded – by about one year – by a negative value for that spread.
Long rates may be pushed higher – widening the yield spread and steepening the curve – by investor expectations that economic growth or inflation will pick up. Conversely, the spread can go negative – or in common parlance, the yield curve inverts – when investors expect a recession and rush to the safety of long bonds.
It is important to recognize four issues. First, the yield curve inverted in 1966 and became nearly flat in 1998 but a recession did not follow.
Second, the yield curve is hardly flat now – the spread is a bit more than 100 basis points. That may be lower than in recent years but is hardly low enough to trigger a significant probability of a recession – for example, as modeled by the Federal Reserve Bank of New York.
Third, there is no significant argument in economic theory that a flattening or inverted yield curve must be a precursor to a recession. It is a statistical correlation like the Sun Spot theory of the business cycle – the latter worked pretty well in the past but missed the Great Recession entirely.
Correlation is not causality. That’s why we have had two false positives for the yield curve, and the underlying factors that give rise to coincidence change over time. In particular, during much of the post-World War II period, capital markets were more Balkanized than today.
Nowadays, when the Fed pushes up short rates, significant amounts of foreign money can more easily rush in as long rates try to rise. That can distort the meaning of a resulting flatter yield. Even without Fed action, the current political turmoil in Germany and elsewhere in Europe, for example, could push U.S. long rates down and flatten the yield curve for reasons having little to do with underlying U.S. economic conditions or Fed policy.
Finally, since President Donald Trump was elected, the spread has narrowed from 1.45; however, it is not even close to zero, and offers no cause to panic.
Several issues are weighing on long rates during the latter part of this recovery.
Globalization has increased wage arbitrage and, despite low unemployment, no signs are apparent that wage inflation will overcome recent improvements in productivity growth to push non-oil inflation much above 2 percent. Hence, the Fed should have no need to push up the federal funds rate more quickly than outgoing Chairman Janet Yellen has led markets to expect.
The real long-term price of capital is lower these days. Firms need less of it to create value in an economy driven more by digital technologies than heavy industrial assets. That simply has lowered the demand for financing, and stocks are hardly overpriced with P/Es in line with 25-year averages.
Although years of easy credit have created risks among lower-grade corporate bonds and in securitized leverage loans used by lenders to finance private-equity firms and hedge funds, those risks would likely only actualize into serious trouble if the Fed moved up rates more abruptly – again an unlikely scenario.
The big issue remains the tax bill moving through Congress. A failure by the GOP Senate would deliver a body blow to equities markets and that could set off a panic – not merely among equity investors but also CEOs making business expansion and hiring decisions, and consumers who are already saving too little.
These days, politics poses more threats to the economy than the machinations of the bond market as measured by the slope of the yield curve or any other metric.
Peter Morici is an economist and business professor at the University of Maryland, and a national columnist. © 2017, The Washington Times