Is an inverting yield curve a result of climate change? Quantum mechanics? A malfunctioning traffic sign? All good guesses, but no. Here’s the worry:
“The spread between the 2- and 10-year Treasury yield narrowed further in August as the yield on the 10-year Treasury stood only 25 basis points above that of its 2-year counterpart. The high-level macroeconomic concern is that the current path will ultimately lead to an inverted curve, which has historically been a precursor to recession.” (Pension & Investments, August 14, 2018)
Here’s the history of the yield curve and recessions:
Sources: Bureau of Economic Analysis (BEA), the Federal Reserve, the Department of Labor.
The chart does show that yield curve inversions precede recessions. Why? The theory is that the Federal Reserve responds to a strong economy and rising inflation by raising its fed funds rate, which drives the short-term end of the yield curve. The Fed’s idea is that pushing up interest rates will slow economic activity by reducing borrowing and spending. In response, investors see the Federal Reserve’s behavior and buy bonds, betting that a recession is coming and that the Fed will eventually reverse its policy and drive interest rates lower down the road. So higher short-term rates and lower long-term ones.
Does this theory hold water? No, it does not. The data tells a different story.
The real credit cycle driver.
Three charts tell the alternative story. The charts analyze car sales. Most people borrow to buy a car, so changes in Fed-driven interest rates should have a big influence on car sales, right? Wrong, as this chart shows (note that I inverted the car loan rate data because lower rates should mean more car sales):
Sources: Federal Reserve, BEA
The chart shows that car sales are no higher today than 15 years ago, despite far lower auto loan rates. And the sharp decline in car sales in ‘08/’09 was despite falling borrowing rates, while the big rise from 2013 to 2016 was despite flat rates. Do lending practices have anything to do with car sales? Absolutely. But it’s not the interest rate, it’s lending standards, as this chart clearly shows:
Sources: Federal Reserve, BEA
The less money down, the greater the sales. Think of all of those “No money down” car ads on TV. (BTW, note that the Fed ended this quite useful data series in 2009. Damn government.) Finally, what drives changes in lending standards? Once again, my benighted data has the answer:
Source: New York Federal Reserve
Lending standards, defined here as the median FICO score, tighten when loan delinquencies increase, and vice versa. Makes sense. So what is the Federal Reserve up to with its fed funds changes? To explain, you’re not going to believe this, but I’ve got a chart. This one compares fed funds changes to the real driver of lending cycles, which is loan delinquencies:
Sources: Federal Reserve, Department of Labor.
The Fed seems to raise its funds rate well after a loan delinquency trend has been underway. They are reactive, not proactive. So while the first chart above seems important, it just shows the Fed following a change in GDP that is already underway.
So keep your eye on the real GDP cycle driver, which is loan delinquencies. The chart above shows they currently are quite low. You can therefore ignore the yield curve inversion risk and continue to overweight stocks.