Source: Barron's Author: Randall W Forsyth

Economist Robert Solow (Robert Solow), an economist who died in December last year, once said that everything made Milton Friedman (Milton Friedman, a famous American economist, who won the Nobel Prize in Economics like Solow) think of the money supply, then quipped, “Everything reminds me of sex, but I won't write it in my paper.”

I, on the other hand, may be “accused” of being overly “obsessed” with yield curves. Historically, the shape of the yield curve is an indicator for predicting future economic conditions: the yield curve is usually sloping upward, which means that the economy may expand in the future; when the yield curve is tilted downward, or inverted, it is often an early warning sign that the future economic situation will become more severe, and lower interest rates will follow.

The most powerful indicator of the yield curve is the end of the “tug-of-war” between the Federal Reserve and the bond market. Federal funds rates are set and adjusted by the Federal Reserve, and the bond market has always been free to price long-term borrowing costs based on its own expectations of monetary policy and the economy.

Currently, both ends of the yield curve have been influenced by the Federal Reserve. The Federal Reserve's massive purchases of US Treasury bonds and mortgage-backed securities led to a decline in medium- and long-term yields, distorting the shape of the yield curve. More importantly, although the Federal Reserve has begun to shrink, the liquidity injected by previous large-scale bond purchases has made the financial environment more relaxed.

Campbell Harvey (Campbell Harvey) is a veteran of yield curve analysis. He explained the reliability of this indicator in his doctoral dissertation published in 1986. Harvey is currently a professor at Duke University's Fuku School of Business and is also a senior consultant and research director at Research Affiliates. His research shows that since 1969, the eight previous recessions occurred after the yield on 3-month US bonds was higher than the yield on 10-year US bonds. After the yield curve was inverted, the financial environment tightened, and the economy inevitably fell into recession.

Since the 3-month US Treasury yield was higher than the 10-year US Treasury yield in November 2022, the yield curve has been inverted for 19 months. So does this mean that this once awesome leading economic indicator is useless? Harvey's answer: No.

Harvey pointed out in an interview that the above time interval is consistent with what the past eight economic cycles have experienced. According to his research data, the yield curve began to reverse 19 months before the economic recession from November 1973 to March 1975, and 18 months before the brief and sharp recession from January to July 1980, the yield curve began to reverse.

Eighteen months before the recession of December 2007 to June 2009, the yield curve began to reverse. The difference in this cycle is that starting in mid-2004, the Federal Reserve under Alan Greenspan (Alan Greenspan) raised the federal funds rate by 25 basis points, peaking at 5.25% two years later, and then remained at this level until September 2007, when “cracks” began to appear in the money market.

In contrast, this time the Federal Reserve raised the federal funds rate by 525 basis points in a very short period of time. From March 2022 to July 2023, the federal funds rate target range increased from 0%-0.25% to 5.25%-5.50%. However, after 19 months of inversion of the yield curve, the US economy did not fall into recession.

Harvey believes that it is too early to say “the signals released by the yield curve are useless.” In the past cycle, banks' ability or willingness to lend has always been curtailed by the Federal Reserve's interest rate hikes. Interest rate hikes have led to an increase in the cost of banks absorbing deposits, and profit margins brought about by bank loans have either declined or been zero. Currently, banks that are “too big to fail” continue to pay negligible interest to depositors while allowing customers who want more profit to switch to money market funds, bringing sufficient margin room for these banks.

Harvey also mentioned other non-monetary reasons why the inversion of the yield curve did not trigger the recession. Massive federal spending continues to drive economic growth, even though previous stimulus checks have been spent. He also pointed out that corporate executives carried out “risk management” based on traditional warning signals from yield curves. One prominent (but by no means unique) example is Facebook's parent company Meta Platforms (META), which made large-scale layoffs during the 2023 “efficiency year.” But the US unemployment rate remains at an all-time low of less than 4%.

However, the Federal Reserve's own actions also seem to be an important factor. Tom Becker (Tom Becker), portfolio manager of BlackRock's global tactical asset allocation team, pointed out in a recent report that the huge treasury bonds and mortgage-backed securities held by the Federal Reserve may have lowered their yield by more than 200 basis points, or even 400 basis points.

Becker wrote, “The easing effect of the Federal Reserve's balance sheet has also surpassed all estimates in the decade before the pandemic. This helps to understand the resilience shown by the US economy during policy tightening in 2022 and 2023, and the continued inversion of the yield curve.”

Harvey said that there is a problem with this view, and that is that the Federal Reserve has been downsizing. As of last Wednesday (May 22), the Federal Reserve's securities holdings fell from a peak of 8.5 trillion US dollars in March 2022 to 6.9 trillion US dollars.

However, Becker further added that most of the reduction in the Federal Reserve's securities holdings was achieved by allowing shorter-term securities to expire without replacing them. He estimated that this so-called quantitative austerity had an effect of only 25 to 50 basis points, while quantitative easing estimates for 2020 and 2021 had an effect of 140 to 290 basis points.

Although the yield curve is inverted, the US economy continues to grow, the unemployment rate is very low, and inflation is still far above the Federal Reserve's long-term target of 2%. The financial environment remains relaxed, as can be seen from the fact that major stock indexes are close to historical highs and credit spreads are narrowing. All of this will prevent the Federal Reserve from cutting interest rates.

edit/lambor