July is truly upon us, and that means half the year is gone. Those who deal with numbers are busily tallying up all sorts of statistics for the first two quarters. Business people with large and small companies alike are checking to see how the numbers compare with last year, and what they can do to improve the depressed
bottom line — or maintain the improved bottom line for the next six months. And for those of us in the stock market with pension plans or investments, there will be half-year statements coming to let us know how we stand.
As we are taking stock of our stocks, there is this interesting bit of news to consider. According to a recent article by Matt Phillips in The New York Times, we are getting an important signal from the bond market. Now there are all sorts of predictors about which way stocks will move, from who wins ballgames to the length of hemlines, and they are often as wrong as the Farmers’ Almanac about the coming winter weather. But there is one telltale that is surprisingly accurate: the bond-yield curve. And that yield curve is “flashing yellow.”
Here is what the yield curve means. The yield curve is the difference between interest rates on short-term government bonds like those maturing in two years compared with those maturing further out, like 10 years. Remember that a bond is a promissory note to repay a debt that the government has incurred, along with interest on the debt, for a set period of time.
So, if the government borrows $10,000 from you and pays it back in two years, you will also get interest on that sum in return for lending the government the money. Normally the longer you agree to lend the money, the higher the interest rate you get in return for taking additional risk concerning the health of the economy. A healthy economy usually encourages inflation, which is countered by higher interest rates — hence an increased long-term rate, including the built-in risk compensation.
Lately, long-term interest rates on government bonds have been slow to rise, predicting a less healthy economy on the horizon. The short-term interest rates on government notes, as these instruments are called, have been rising, however, because inflation seems to have started. So the difference between the interest rates, short-term and long-term — the yield curve — has been decreasing or “flattening.” The difference between the two-year and 10-year interest rates is now about 0.34 percentage points, and the last time it was so little was just before the 2008 recession.
Does that mean a recession is coming?
If the trend continues, and the long-term interest rate dips below the short-term rate, this is called an “inversion.” An inversion is, according to the way John Williams — the new president of the Federal Reserve Bank of New York — told it earlier this year, “a powerful signal of recessions.” The Times article indicated that every recession in the last 60 years has been preceded by an inverted yield curve, when short-term interest is higher than that for the longer term. Only once was there a false positive, in the mid-1960s, when there was only a slowdown in the economy. That is why economists and those on Wall Street are watching the yield curve so closely these days.
This concern does seem to fly in the face of the present economic conditions. Unemployment is at a low, consumers seem to be happily spending and corporations are reinvesting in their companies. However accurate the yield-curve predictor may be, it cannot precisely tell us when a recession will occur. In the past, the falloff of the economy could happen in six months or two years after the inversion.
There is always another side to every story. Because central banks own massive amounts of government bonds, which they bought not so long ago to try and stimulate the economy by providing liquidity, that may be keeping long-term rates low. And the Federal Reserve has been tightening monetary policy lately to keep
inflation in check, hence higher short-term rates. So, who knows?