Treasury Yield Curve Isn't Telling Investors Much
(Bloomberg View) -- The Treasury yield curve is a closely watched metric for good reason. But investors fixating on it right now may miss the bigger risk.
In each of the last two economic cycles, the yield curve flattened and then inverted -- meaning short-term interest rates became higher than long-term interest rates -- in the period leading up to recession. The curve is flattening now, and could invert next.
The yield curve is seen as a forecast because it has historically represented a measure of where in the economic cycle we are. When short-term interest rates are low at the beginning of a cycle, the yield curve is steep. Following many rounds of rate increases later in the cycle, the curve tends to flatten. But aside from the yield curve, there are few signs of excess investment in the U.S. right now, or of rapid inflation. Inflation and wage growth are slowly rising yet still not at levels that concern the Federal Reserve, despite years of high employment that ought to pull them up.These are signs that the flattening yield curve is not signaling the same risk as in the previous two economic cycles.
There’s another number that tells us more about the direction of the economy: fixed private investment as a share of GDP.
Out of the various components of gross domestic product (consumption, investment, government and foreign trade), investment tends to be the most cyclical and the driver of recessions and expansions. By looking at spending on residential construction, nonresidential construction, equipment and machinery, and intellectual property -- collectively known as fixed investment -- as a share of GDP over time, we can see whether investment is running above or below average. This indicates whether it's possible there's excess investment in the economy that could fall and cause a recession.
In each of the last five economic cycles dating back to the late 1970s, fixed investment got to around or above 19 percent as a share of GDP. At the end of 2017, it was running at only 16.6 percent of GDP. In this expansion the economy hasn’t even gotten back up to the lowest reading from the last economic cycle. To get up to 19 percent from here would require a nearly $500 billion increase in fixed investment -- and that’s if there is no GDP growth. If GDP continues to grow, fixed investment would have to significantly outpace it to approach “excess investment” levels.
Fixed investment could grow faster than the economy over all, and accomplish this without creating inflation, by drawing workers into the labor market from the sidelines. Another scenario would be fixed investment increasing but not creating inflation because it leads to productivity growth, perhaps via investments in automation and robots.
The other possibility is that the U.S. will indeed face the kind of economic overheating that concerns the Fed -- but starting from a much lower level of investment. The most compelling evidence we have for this right now is in the trucking sector, where freight rates have surged in response to a truck driver shortage.
In any of those scenarios, we may end up with an unusual disconnect between the U.S. economy’s short-term and long-term prospects.
The rates on long-term debt reflect factors that are unlikely to change much over the next few years -- demographics, productivity growth, the Fed's inflation target of 2 percent. Ten-year interest rates are currently a little under 3 percent, which is in line with the Fed's forecast of what interest rates will be over the longer run.
The shorter end of the yield curve is going to be much more variable. Think of short-term rates as "how high does the Fed have to raise interest rates to keep the economy from overheating." If fixed investment does gain as a share of GDP, that level may turn out to be a lot higher than the market currently believes.
What may end up happening is economic growth continues, powered by millennial household formation and years of underbuilding homes following the financial crisis. Yet because of labor shortages, employers scramble to find workers -- and are forced to pay higher wages, which leads to inflation pressures. The Fed would find itself having to continue raising short-term interest rates, which is disruptive to financial markets forced to revalue assets, yet the higher rates don't actually do much to slow growth, given relatively solid fundamentals. Short-term rates could hit 4 percent or higher.
Yet at the same time, because the big picture for the economy doesn’t change, longer-run interest rates would stay around 3 percent. Perhaps two-year interest rates will be north of 4 percent, while 10-year interest rates are around 3 percent, making the yield curve inverted by more than one percentage point, a level it hasn't seen since 1981. An extreme and long-lasting inversion flips a lot of economic models on their heads, a challenge for banks, investors and policy makers.
There’s no cause to panic if the yield curve inverts a little in the next few months. It’s what comes next that counts.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Conor Sen is a Bloomberg View columnist. He is a portfolio manager for New River Investments in Atlanta and has been a contributor to the Atlantic and Business Insider.
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