The yield curve has preceded most US recessions since World War II, giving it a reputation as a reliable leading economic indicator. Fisher Investments agrees it is useful, yet many misinterpret it and why it works. To see how we think you should use it, read on.
The yield curve plots a single entity’s interest rates across the entire spectrum. Government bond yield curves, which are the most widely watched, usually start with the central bank’s policy rate at the short end, then move on to 1-month yields, 3-month, 6-month, 1-year, 2-year and so on, ending at 10, 30 or even 50 years depending on the issuer. The yield curve is “steep” when long-term interest rates are well above short. It is “flat” when long rates are barely above short rates. It “inverts” when short rates top long rates. That inversion typically precedes recessions.
Yield curve proponents say inversion is bad because it means investors are risk-averse, making recession inevitable. But in Fisher Investments’ view, this doesn’t explain the yield curve’s power—its relationship with bank lending is more meaningful. Banks create most new money—fuel for economic growth—through lending. The yield curve greatly influences how much they lend.
Think through a bank’s business model. Banks borrow at short-term rates (usually very short, ranging from overnight to 3-month periods)—mostly via consumer deposits and interbank lending. They lend to individuals and businesses at long-term rates ranging from one month to 50 years depending on what the entity offers—30-year mortgages or 10-year commercial loans are some of the most common examples. The 10-year US Treasury yield—considered the primary default risk-free rate—is the reference rate for long-term loans. Banks will typically charge Treasury yields plus an extra amount to compensate for the higher risk. This, in Fisher Investments’ view, makes the difference between short- and long-term rates a gauge of banks’ potential profits on new loans.
Banks aren’t charities. The amount of risk they take depends on the payoff, which is where the curve’s steepness factors in. When long-term rates are far above short-term rates, potential profits are big—incentivizing lending to a wide range of potential borrowers. This brings faster loan growth and, hence, faster economic growth. A flatter curve means potential profits are slim—incentivizing banks to lend only to the most creditworthy customers—slowing loan growth. An inverted curve risks making lending unprofitable. If the curve remains inverted for long enough, it could cause a credit crunch and recession.
Stocks move most on the gap between expectations and reality. Reading the yield curve correctly can help you gauge whether economic expectations baked into stock prices are too hot or too cold. If pundits say recession is imminent, looking at the yield curve can help you assess whether they are correct or too pessimistic. If it isn’t inverted, that is a sign they are probably wrong, likely creating room for positive surprise to boost stocks.
If it inverts, investigate whether it is a false signal, which is fairly common. A short-term, shallow inversion probably won’t generate a severe disruption. Money crosses borders easily these days. If other countries have significantly lower short-term rates than the US, banks could borrow abroad and lend here for a tidy profit. This kind of arbitrage happens often, which is a big reason Fisher Investments thinks a global yield curve, with countries’ rates weighted according to their share of global GDP, is more meaningful than any single country’s. Plus, while central banks’ benchmark rates get the most attention on the short end, banks’ actual funding costs are market-set. When the yield curve inverted briefly in 2019, banks’ actual funding costs were far below the fed-funds target rate. Banks had more customer deposits than they needed and therefore didn’t raise rates to compete for business. Their near-zero funding costs kept lending plentiful.
Conversely, if pundits’ expectations are hot and they are ignoring an inverted yield curve, this could be a sign sentiment is outpacing reality. Fisher Investments thinks this was the case throughout 2000. At the time, investors were punch-drunk on high-flying dot coms and talk of a “new economy” where boom and bust were no more. When Tech started falling late that March, buy the dips was a common refrain. Meanwhile, after cutting rates in late 1998 to placate Y2K fears, the Fed had to reverse course in late 1999 and early 2000 as inflation jumped past its target. The yield curve inverted briefly that April and suffered a much longer, deeper inversion throughout 2000’s second half. Investors tuning out euphoria and paying attention late that year would have fathomed 2001’s recession—and a high likelihood that Tech’s troubles would snowball market-wide. The S&P 500’s bear market ultimately ran from late March 2000 to early October 2002.
In our view, the yield curve doesn’t predict stocks—one liquid market doesn’t predict another. But the yield curve can help you evaluate the gap between expectations and reality. What are pundits saying about the yield curve? Do their expectations match reality? There is no perfect tool, but a clear view of the yield curve can help you weigh those key questions.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.