December 14, 2018: Market Minute: Confusion about the Curve
Last week, the 5-year Treasury note fell below the 2-year note causing many market watchers to suggest the US Yield Curve is inverting. And as the Curve is a leading indicator to the stock market, the bears came out in force declaring the party has ended.
Nothing could be further from the truth.
The more important yield comparison to watch is the 2-year Treasury note versus the 10-year note.
Lower yields for longer-dated Treasuries relative to shorter-dated Treasuries suggest traders expect economic conditions to soften, thereby easing inflationary pressures. If, in contrast, they expect inflation pressures to intensify, they would demand higher yields on longer-dated bonds.
While the 10-year note continues to yield more than the 2-year note, the gap is decreasing (Chart 1).
The comparison between the 10 and 2-year rates is the most important way to evaluate the yield curve.
Since the mid-1970s, every economic recession in the U.S. was preceded by an inverted yield curve.
Even if the curve were to invert, it does not mean a recession is imminent. The length of time between inversion and the start of the recession has varied between 10 and 18 months.
Chart 1 shows the current yield curve (red line) and the curve one year ago (yellow line).
Another interesting indicator of recessions is housing starts (Chart 2).
Seven out of the last eight recessions were preceded or accompanied by a drop of at least 30% in housing starts. Though the housing market has eased over the last 12 months, it’s nowhere near recessionary levels. Housing starts in October 2018 were down just 2.9% from October 2017.
Bottom line: Given the time-tested evidence, it would be a stretch for any analyst to suggest the secular bull market is at an end.
Though the current market weakness creates the opportunity for the bears to come out, the present position of the US Yield Curve and Housing starts should over ride most concerns.