Rising Rates & A Flattening Yield Curve


Rising Rates and Flattening Yield Curves

Rising interest rates and a flattening yield curve are some things to be concerned about. While the current situation is not dire, inflation is rising and the yield curve is flattening. If these two indicators continue to deteriorate, it might precede a recession.

A recession, as defined by the National Bureau of Economic Research (NBER), is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” Unfortunately, these are all lagging indicators and the NBER can’t officially declare that a recession has occurred until afterwards. This, of course, does not stop nearly every economist or portfolio manager from predicting when the next recession might occur, even if it is a foolhardy endeavor.

Nonetheless, if there is no perfect formula or algorithm to predict such an event, this doesn’t mean that there aren’t a few great leading indicators to consider when looking for potential trouble on the horizon. Here are my 4 favorite indicators:

Four Recession Indicators

Slower Consumer Spending
Rising Unemployment
Inflationary Pressure
Inverted Yield Curve

To be clear, I am not forecasting that a recession is imminent. To the contrary, consumer spending is extremely strong and we just saw the unemployment rate drop to its lowest rate (3.8%) since 2000. Nonetheless, the current state of the two latter points (inflation and the yield curve) is worth covering in greater detail due to its importance.

Rising Inflation

Inflation levels, which have been rising from their lows in 2015 after briefly dipping below 0.0%, are currently at 2.43%. Modest inflation is generally good for an economy. Rapid inflation or deflation can be devastating for an economy. The Fed has a 2.0% target inflation rate and it looks as if we have finally reached and surpassed this figure.

Core CPI has been rising

In response to rising inflation levels, the fed will raise interest rates to temper this growth. In addition to real inflation rising, expected inflation has also been rising.

inflation expectation

Should this be concerning? Not really as things are not out of control. Though, it is worth keeping an eye on. If the Fed is forced to take a more aggressive stance on rising inflation, the capital markets (including equities) and the overall economy will feel the price.

Flattening Yield Curve

A yield curve is a curve that shows interest rate points across several maturity dates. Most commonly plotted chart is the US Treasury bond yield curve due to its importance in the economy (after-all, it is the largest and most widely-held security in the world).

A normal yield curve will show a normal risk appetite among investors (lower rates among shorter maturities and higher rates among longer maturities):

normal yield curve

However, the yield curve has been flattening, meaning that the gap between short and long-term treasury rates has narrowed.

Flattening Yield Curve

Another way to determine if the yield curve is flattening is to measure the gap between the 10-yr and 2-yr Treasury rates.

10 to 2 yr Treasury Spread

As you can see, nearly every time that the spread has inverted (dropped below 0.0%), a recession has occurred (shaded area on the chart). The current 10-2 yr Treasury spread is 0.43%, down from 2.66% on December 31, 2013.

Conclusion

Some would argue that because the yield curve is flattening and inflation levels are rising, it should be a time to panic. However, it is worth noting that the yield curve has not yet inverted and inflation levels are not out of control. There is no need to ring any alarm bells at this point in time. Even if the yield curve does invert soon, this is still only one indicator, albeit an important one, out of the 4 recession indicators I mentioned above.

 


 

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