INSIGHTS

On June 29, 2015

AAM Viewpoints – The Continuing Relevance of the Yield Curve

“The brains of humans contain a mechanism that is designed to give priority to bad news.”

-          Daniel Kahneman, Thinking Fast and Slow

Kahneman is a leading proponent of understanding the biases to which we are all subject. From the foods we eat to the context of our environment, we each are often subtly influenced by forces which appear to be minor but can have undue influence on our decisions. However, one of the most stunning observations he and his peers have made is remarkably relevant to anyone turning on financial news in the morning: bad news sells.

AAM’s economic outlook may not be geared to noisy and graphically intense financial networks. Our outlook doesn’t include excessive hyperbole, bold proclamations of doom, nor delusions of grandeur. Whereas many economic prognosticators discount the information we feel the yield curve is providing us, we continue to share our outlook so as to engender a calm, collected and intelligent method of investing based upon the facts. AAM has consistently discussed the value of the yield curve as a leading indicator of economic activity. In this week’s Viewpoints, I’m going to step back and given some detail to our use of the yield curve in our investment outlook.

First though, a few basics are important to help dispel the “this time it’s different” mentality which is prevalent when discussing the yield curves forecasting potential.

The Treasury curve consists of a variety of maturities from short- to longer-dated Treasury issuance. Generally speaking, the longer part of the Treasury curve is influenced by market participants, whereas the short-term market is generally under the purview of the Federal Reserve. Longer-dated Treasuries tend to yield more than shorter-dated maturities, and the difference between specific maturities is considered the yield spread. For example, if the 10-year Treasury is yielding 5.00% whereas the 2-year Treasury is yielding 2.00%, the spread between these two points on the curve is 3% or 300bps (basis points).

While my discussion will focus on the relationship between the 10-year Treasury and the 3-month Treasury bill, the relationships between the short and the long end of the Treasury curve tend to be consistent regardless of tenor. In general, an investor gets paid a higher yield to hold longer-dated Treasuries than to hold shorter-dated Treasuries.

This relationship has been the subject of much research (and speculation) because the spread between these parts of the curve has historically given us some insight into future economic activity. It is perhaps this simplicity that gives rise to the idea that looking at the yield curve is a fool’s game given the Fed’s quantitative easing programs over the past few years. However, it is the simplicity of this relationship that may very well be the primary reason for the effectiveness of using the spread as a guiding factor in developing an economic outlook.

In and of itself, the Treasury spread can serve as a primary piece of evidence for economic activity. While the difference between the longer and shorter ends of the curve gives us no information as to the rate of growth in the economy, we continue to feel it provides a view future economic activity four to six quarters in advance. The Federal Reserve has a body of research that illustrates this relationship in greater detail.

Below is a graph of the yield spread between the 10-year Treasury Bond and the 3-month Treasury Bill.

• Grey bars indicate an economic recession
• Red Boxes highlight yield curve inversions (3-month yields > 10-year yields)
• Green line illustrates the average spread of 155bps

Source: St. Louis Fed

It is important to understand clearly that the relationship between the long and short end of the treasury yield curve exists across all tenors. Whether you use the 30-year or 10-year as the long-term Treasury anchor or the 5-year, 2-year or 3-month Treasury as the short anchor, this relationship is consistent.

Generally speaking we find that:

• Steep yield curves tend to occur during expansions,
• Flat yield curves are economic inflection points, and
• Inverted yield curves tend to precede recessions.

The conclusions we can draw from the relationship between the long and short end of the Treasury curve is perhaps best summed up with by Estrella and Mishkin’s study from 1996:

“The yield curve…is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recession two to six quarters ahead.”

- Arturo Estrella & Frederic S. Mishkin, “The Yield Curve as a Predictor of U.S. Recessions”, Current Issues in Economics and Finance Vol 2, No. 7 06/96

As simple as it may seem, there is a preponderance of evidence that consistently shows the usefulness of the yield curve in forecasting future economic activity. The relationship between the long and the short end of the yield curve allows us to augment our other macro-economic analysis to either confirm or reconsider our assessments of the future.

When we consider the outright pessimism from many market forecasters, we feel it’s important to place those claims against the data, especially data that has some historic relevance.

What we find is the following:

• The United States has not entered a recession when the Fed Funds rate was not being actively increased.
• It is not a single rate hike, much less one at the beginning of a rate-hike cycle which causes the economy to slow down.
• The preponderance of change in the yield curve leading up to a recession is driven by short-term rates and the FOMC (Federal Open Market Committee), not long-term rate compression. We encourage you to not be lured by the siren song of, “this-time-it’s-different – it is” which infects discussions about the long end of the curve.

Given the lead time of yield curve changes to economic activity, it is important to use additional economic data to confirm what the yield curve is forecasting. Looking at other economic data today shows how preposterous we think it is to claim that the economy is on the cusp of a recession. That is not to say that growth less than 3% is desirable, but merely to say that prophets of doom understand that “bad news sells.”

Below is a short list of economic data we use to balance our guidance from the yield curve:

• Institute for Supply Management Report on New Orders
• The month-over-month change in the Conference Board’s Leading Economic Indicators Index
• Department of Labor Initial Jobless Claims

Yield curve flattening without other corroborating economic data is not unlike flying an airplane in instrument conditions with only the airspeed indicator. Yes, it provides important information and we have good reason to respect what it is telling us. After all, the airspeed indicator is one of the first instruments to be fitted to an aircraft and it has a long history of reliability. Even in an age of glass-cockpits, this relatively simple instrument provides pilots with relevant and critical data. However, we would never use it without additional input from other important instrumentation.

CRN:  2015-0629-4807R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.