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The Independent Adviser for Vanguard Investors
•
August 2016
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money sitting in checking and savings
accounts doesn’t just sit there, though.
The bank then lends that money out
at long-term rates (for instance, in
the form of a 30-year mortgage). The
steeper the yield curve (long rates
yielding more than short rates), the
greater the profit the bank makes on its
loans and the more likely they are to
lend, which spurs economic activity. If
the yield curve is not very steep, then
banks are less inclined to lend, and
economic growth is stunted.
So, as I said at the outset, the shape
of the yield curve has some bond mar-
ket watchers concerned that a reces-
sion is fast approaching. What has
sparked the current worry is the fact
that the difference between 10-year
and 2-year Treasury yields has been
shrinking—the yield curve has been
flattening dramatically. Today, with
the 10-year Treasury yielding 1.46%
and the 2-year yielding 0.66%, the
spread is just 0.80%. The “flat-landers”
are focusing on a chart similar to the
middle one above, which plots the dif-
ference in 10-year and 2-year Treasury
yields, to highlight the fact that the last
time the yield curve was this flat was
in late 2007 and early 2008, when the
economy was headed for recession and
stock markets were poised to be cut in
half.
Take note that the yield-curve story
making the rounds today is being
framed to raise your alarm bells. But
does it really signal the onset of another
recession and bear market? I don’t
think so.
Let’s step back and take a broader
historical perspective than one focused
solely on the last recession. The graph
on the right shows the spread between
10-year and 2-year Treasury yields back
to
500 Index
’s inception in
September
1976 (we’ll tie in the stock market in
a moment) and highlights recessions in
grey bars. The reality is that the yield
curve isn’t very helpful in predicting
recessions until the 10-year yield falls
below that of the 2-year—a fairly rare
situation referred to as an “inverted
yield curve” in market lingo. And note
that an inverted yield curve (when the
blue line falls below zero) can be an
early warning sign, but is definitely not
an immediate trigger or sign of a nearby
recession.
Yes, the spread between the 10-year
and the 2-year Treasury was last below
1% just before the Great Recession. But
at that time the yield curve was steep-
ening from an inverted level. It wasn’t
Today’s Yield Curve
7/16
7/21
7/26
7/31
7/36
7/41
7/46
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
Maturity Date
Yield Spreads at Pre-Crisis
Levels? Panic!
6/08
6/09
6/10
6/11
6/12
6/13
6/14
6/15
6/16
Diff. in 10-Yr and 2-Yr Treasury Yields
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
Yield Spread
Recession
coming down from a steep level, as it is
doing today.
Looking further back, you’ll see the
Treasury market spent much of the late
1990s with the yield curve well below
1%, but it wasn’t until the curve invert-
ed that the U.S. was on the verge of a
recession. The same could be said for
the 2008 recession, as well as the 1979,
1981 and 1991 recessions. In fact, the
time between the yield curve’s inver-
sion and the ensuing recession ranged
from 11 months to 19 months for the
five recessions we’ve experienced over
the past 40 years.
So, I’d posit that today’s flattening
yield curve is not a harbinger of a reces-
sion—yet.
But doesn’t the sheer fact that a flat
yield curve could lead to an inverted
one mean that a recession and a stock
market decline are just around the cor-
ner? Contrary to the cautionary tone
struck by many bond market mavens,
today’s yield curve suggests we are
actually in the sweet spot for strong
stock market returns going forward.
My colleague atAdviser Investments
Brian Mackey (who initially shined
The Sweet Spot for Stocks
SPREAD BETWEEN 10-YEAR AND
2-YEAR TREASURY YIELDS
<0% 0%–1% >1%
Full Time
Period
% of Time
16% 36% 48%
100%
Avg. Return of 500 Index Over Next 12 Months
9.0% 16.2% 10.5% 12.3%
Frequency of Loss Over Next 12 Months
36% 16% 17%
20%
Yield Spreads Need to
Invert to Flash Yellow
6/80
6/84
6/88
6/92
6/96
6/00
6/04
6/08
6/12
6/16
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
Yield Spread
Recession
Diff. in 10-Yr and 2-Yr Treasury Yields
>
SEE
WRONG
PAGE 16
Contrary to the
headlines, today’s
yield curve suggests
we are in the
sweet spot for strong
stock market returns.