“Fed-splaining” Away The Yield Curve

Investors, beholden as they are to capital markets, tend to believe market signals over most other indicators. “Price leads fundamentals” is their mantra. This is especially true when the markets in question are outside a given investor’s core competence. For example, equity guys/gals tend to look at the bond market for signals on issues like long-term inflation expectations, or options markets for signs of shifting risk perceptions. Lacking deep subject matter expertise, they will almost always default to prices generated by other markets in forming their investment perspective.

Central bank policymakers are different; they view their job as predicting future economic conditions and then adjusting monetary policy accordingly.In their world, market prices may be right or wrong as predictive indicators. In the bankers’ defense, markets do get things spectacularly wrong on occasion. Don’t forget that the US 10-Year Treasury yielded 5% in June 2007. It bottomed 9 years later at less than 1.5%.

Put in front of these two groups a chart of the “steepness” of the US Treasury yield curve (2 vs. 10 Years) and you’ll hear a dramatically different take on that squiggly, downward trending line:

• Equity investors: “If the chart of the Treasury yield curve were a stock, no way would I buy it. It makes a new low almost daily. At 25 basis points on Friday’sclose, we’re within shooting distance of zero. That makes me nervous. I’ve read the Fed’s own papers on this topic, and they say a negative curve is a signal of an impending recession.”

• Federal Reserve official: “While I will keep a close watch on the yield curve as an important signal on how tight financial conditions are becoming, I consider it as just one among several important indicators. Yield curve movements will need to be interpreted within the broader context of financial conditions and the outlook and will be one of many considerations informing my assessment of appropriate policy.”

• The first quote is our invention, a summary of many conversations with market participants; the second comes directly from Fed Governor Lael Brainerd.

The difference between the two perspectives comes down to how varying constituencies use hard data in their analysis.

• Equity investors gravitate to datasets with long track records of predictive value, ideally with daily frequency. Such data should originate from a large pool of participants, so it is representative of aggregate sentiment. The shape of the Treasury yield curve checks all these boxes extremely well, as do other popular datasets like POS information on retailers’ sales or satellite imagery of theme park parking lots.

• Fed policymakers want to maintain maximum flexibility and independence from any outside influence, whether that be elected officials or capital markets. They will never acquiesce to using one indicator as a measure of appropriate monetary policy. Even one with a very good track record, like the shape of the curve.

All this makes for an uncomfortable narrative, which is why we’re talking about it now. Equity markets and the Fed use and interpret data very, very differently. The former is always looking for a simple “Hack” to get an edge; the Treasury curve fits that bill. The latter embraces intellectual complexity far more ardently; the curve is just one tool.

Based on that assessment, here is what we expect to happen as the yield curve trends closer to zero over the balance of 2018:

• More US equity market volatility around major economic releases like the Employment Situation Report and inflation data. The “recession countdown clock” starts once the 2-Year yields the same as the 10-Year Treasury. After that, equity markets will want to see employment growth continue and inflation remain contained before it believes the Fed’s “It’s different this time” storyline about the yield curve.

• Greater volatility in US consumer sector names and other cyclical sectors, for all the same reasons as the prior point.

• More conversation about US equity market structure as volatility increases. This issue fell to the background as domestic stocks rallied the last few years. But the current structure remains untested in stressed markets, and we expect to see more of those in the next 12-18 months.

In the end, we don’t believe US equity markets will roll over just because the yield curve inverts. There’s plenty of historical evidence it can continue to rally even when 2s yield more than 10s. It just won’t be a very comfortable ride.