As it has often been said, the bond market is a bit better at forecasting the future than the stock market. Evidence for this argument is presented as the difference between 10 year treasury yield and the 2 year treasury yield. The predictive power of this simple calculation for recessionary risk is strong.
A term premium is the added amount of interest an investor is given for locking up their money for longer. They may be forced to reinvest at a time of lower rates, as the further out in the future we go, the harder it seems to be to predict such things. The term premium has been decreasing at the long end of the curve. This is why some, Chair Yellen included, has been discrediting the predictive power of the ten minus two this time around.
Without a healthy term premium, and because infallible Treasuries inherently lack a credit premium because they can print money ad infinitum, all that is left is an inflation premium. Perhaps policy-makers are not as frightened because if inflation were to pick up, the long end should rise at a more aggressive pace than their short-maturity brethren. Is this why they are committed to increasing short rates at a steady and projected clip? They must believe underlying inflation is ready to break, or perhaps it is that they want to remain stoic so as not to cause fear in the markets.
At a minimum and in a worst case scenario, if the fed were just telegraphing strength and certitude, and if there was truly very little inflation, their rate of change in short term rates should give them a little more room to ease if our gross output were to recess. Where issue is taken though, is the disregard for a capable and mostly reliable indicator.
Although there was an early (read false?) signal a two years prior, during the tech bubble, the curve inverted. In a February 2000 article from the Wall Street Journal, if was written off as a consequence of the Treasury’s Buy-Back Program stating “Normally, yields are higher for longer maturities of bonds to compensate investors for the greater risk of lending their money for longer periods. But last month, after the Treasury Department announced a buyback of Treasury securities, some people flocked to buy 30-year bonds on the assumption that that maturity would benefit from the buyback program. Those purchases pushed the yield of the 30-year issue below that of shorter maturities. Traders and investors say the inversion of yields has made it more difficult to assess the value of nongovernment bonds, such as corporate and muni issues, which are valued in relation to Treasurys.”
During 2006 the curve inverted as well. This was written off. See this CNN article from January 2006 saying, “The Fed has publicly discounted the usefulness of the yield curve as an economic indicator, saying that other factors, such as a heavy flow of overseas capital into the U.S., have driven the yield on 10-year notes to abnormally low levels — distorting the yield curve’s predictive abilities.”
We have not inverted yet, but to disregard such a reliable sign instead of exercising a degree of prudence is for fools. There will always be an excuse as to why a certain phenomena occurs this year, but what is often forgotten is that interest rates are the actual underpinning of our economy-no matter how they arrived at their prices. Therefore, if our yield curve inverts, the pricing of credit-related issues will be erroneous, banks will not make money from “paying short rates and receiving long”, and stock valuations will skyrocket due to an artificially sweetened discount rate.