The Bond Market’s Yield Curve Has Lost Its Way

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The bond market’s yield curve has a sort of mythical hold on economists and investors. It’s easy to see why, given that every recession since the 1950s has been preceded by an inverted curve, which happens when short-term rates rise above long-term ones. And right now, the curve is the most inverted it has been since 2000, with yields on two-year Treasuries almost 0.42 percentage point higher than those on 10-year Treasuries.

Naturally, that has many market participants saying a deep, long and nasty recession is on the horizon. But what if the yield curve is sending a much different message, one that is the opposite of an economic doomsday scenario? Perhaps the message is that the Federal Reserve will ultimately be successful in getting inflation back under control and closer to its 2% target and that a recession can be avoided. That would be beneficial to companies, consumers and financial markets. (The economy may have met the technical definition of a recession by contracting mildly in the first and second quarters, but it won’t be considered one unless the private National Bureau of Economic Research deems it one.)

Sure, this may be wishful thinking, but the latest economic data suggest it could actually happen, starting with the monthly employment report that was released Friday. It showed that 528,000 jobs were added in July, exceeding the median estimate of 250,000 in a Bloomberg survey and well above every one of the 71 forecasts. A few days earlier, the Labor Department said that although total job openings decreased by 605,000 in June from May, at 10.7 million they remain double the long-term average going back to 1999.

Also consider the Institute for Supply Management’s gauge of manufacturing activity. At a reading of 52.8 for July, it’s comfortably above the 50 level that marks the dividing line between expansion and contraction in that part of the economy. The organization’s sister gauge of the services economy unexpectedly rose in July. Overshadowed by those two reports was the Commerce Department’s release of factory orders for June, which showed a 2% advance, a 10-fold increase over the average in the decade before the pandemic.

As my Bloomberg Opinion colleague Jared Dillian noted last week, many consumer-facing companies that would normally be the canaries in the coal mine for those looking for evidence of an impending recession, such as Starbucks Corp. and Uber Technologies Inc., are enjoying pricing power and doing quite well, bolstering the case for a so-called soft landing. And travel companies are experiencing booming demand, with Marriott International Inc. saying hotel occupancy has nearly returned to pre-pandemic levels. Overall, members of the benchmark S&P 500 Index are on track to post record profits for the second quarter. 

To be clear, there is nothing inherent about an inverted yield curve that causes a recession. In the six inversions since the 1970s, a recession started an average of 20 months afterward, ranging from 10 months after September 1980 to 33 months after June 1998, according to research firm Statista. A lot can happen in 20 months, as the onset of the pandemic has demonstrated. And it’s arguable that the last extended period of inversion — in August 2019 — was a false positive. Yes, the economy went into a deep recession in the first half of 2020, but that was caused by the pandemic lockdowns. Covid-19 was not on anyone’s radar screen in August 2019. At that time, the concern was that the record economic expansion was tiring and that consumers were running out of steam.

Some strategists say the yield curve’s predictive ability has diminished since the financial crisis of 2008 and 2009 and as the Fed and other top central banks have become more intertwined with bond markets. Those at Wells Fargo & Co. wrote in a research note in March that, as a result, “the link between curve shape and growth has been weak at best since 2009.” As they point out, the curve flattened steadily from late 2013 to late 2019, yet gross domestic product growth was stable. 

An inverted yield curve should in theory have some negative influence over the economy through the banking system. That’s because banks make money by borrowing at short-term rates and lending it out at long-term ones, and an inverted yield curve should make them less willing to provide funding. But that’s not happening. Fed data show that commercial and industrial loans outstanding have soared by $221.4 billion this year to $2.71 trillion. Not including 2020, when borrowers tapped their credit lines for cash during the early days of the pandemic, this is already the busiest year for lending after 2007’s $235.1 billion, according to data compiled by Bloomberg.

So if not a recession, what’s the yield curve’s message now? Quite possibly, it’s that the current high rates of inflation will be coming down in short order. Breakeven rates on five-year US Treasury notes, which are a measure of what traders expect the rate of inflation to be over the life of the securities, confirm that idea. They have declined to less than 2.70% from as high as 3.73% in March. The outlook among consumers for inflation over the coming years has taken a big drop, according to the latest such survey released by the Federal Reserve Bank of New York this week. Expectations for inflation three years ahead fell to 3.2% in July from 3.6% the previous month in the second consecutive monthly drop.

No doubt the improved outlook has something to do with the recent drop in fuel and food prices after a big run-up. The American Automobile Association says that gasoline prices have fallen almost $1 a gallon since mid-June. The United Nation’s World Food Price Index dropped in July by the most since January. The Bloomberg Commodity Index is down 14% from its high this year on June 9. 

The thing to know about the yield curve is that the Fed has tremendous influence over the short end through its ability to push the target federal funds rate higher or lower. It has almost no influence over the long end, which is set by the market and reflects both inflation expectations, the outlook for short-term rates in the future, the supply of bonds and estimates for growth, among other things.

It’s not as if the chief factors that contributed to tame inflation over the past few decades, namely technological innovation and an aging population that favors saving, have gone away. Perhaps the one exception may be globalization. But if we’ve learned anything from the pandemic-era economy, it’s that the old playbooks are largely irrelevant. Nobody predicted with any degree of accuracy what would come after the economy was shut down, some 17 million were booted from the workforce and the government injected trillions of dollars directly into the pockets of consumers and businesses. And we’re still working through the fallout. In that sense, it wouldn’t be crazy to think that perhaps the yield curve has lost its crystal-ball abilities. More From Other Writers at Bloomberg Opinion:

• Team Soft Landing Is Starting to Pull Ahead: Jared Dillian

• Blame History for Making Recession Calls So Hard: Justin Fox

• Corporate Bond Market Didn’t Get  Recession Memo: Jonathan Levin

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Robert Burgess is the executive editor of Bloomberg Opinion. Previously, he was the global executive editor in charge of financial markets for Bloomberg News.

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