INSIGHTS

On February 27, 2017

AAM Viewpoints – The Economic Impact of the Yield Curve

Many who follow the markets, pay specific attention to the U.S. Treasury yield curve as they feel that the Treasury yield curve most accurately evaluates the current health of the economy. The steeper the curve, the healthier the economy – or to put in it in an opposite extreme, a negative yield curve predicts a recession. In fact this occurred three times during the last 30-year period: the recessions of 1990, 2001 and 2008. It does not matter what the reasons given were for the inverted yield curve, a recession followed.

Some have pointed out the yield spread between the 30-year Treasury and the 5-year Treasury has tightened over the last five years questioning the health of the economy.

The yield curve tightening over the last five years could imply that the Fed may not be that aggressive raising the Fed Funds rate as the economy may not be doing as well as some may think. Given that there have been four Federal Reserve tightening cycles in the last 20 years: 1994, 1997, 1999 and 2004, let’s look at the 30-year Treasury yield vs. the 5-year Treasury over a longer period.

Below is the yield spread between the 30-year Treasury and the 5-year Treasury over the last 30 years.

The current spread between the 30-year Treasury and 5-year Treasury is 116 bps (basis points) which is right around the 30-year average as illustrated above. A long way from an inverted yield curve.

Additionally, the new administration is pushing for lower tax brackets, lower corporate taxes and major Federal infrastructure initiatives. This could increase consumer spending and capital expenditures not to mention higher federal debt levels all of which would arguably lead to a more robust economy. It would follow that this could be inflationary and call for a more aggressive Fed Funds rate policy. 

So where do the current metrics sit historically for those who believe that economics revert to the mean?

The 10-year Treasury registered its all-time low yield the close of business (COB) 7/8/2016 at 1.35%. The highest yield recorded on the 10-year Treasury was a 15.84% at close of business (COB) 9/30/1981.  Currently, the 10-year Treasury yields a 2.33%. 

Regarding Fed hikes, historically, how often has the Fed taken action?  As you can see below, the Fed has been really quiet recently as compared to past decades.

Source: Bank of America Merrill Lynch

So whether one believes the economy is doing well and may become more heated with current administration policies and/or one believes in a reversion to the mean, it appears that the Fed actions going forward likely will not be a one and done, but a more long-term hawkish approach to interest rates.