One of the first things we learned while getting trained in the bond-markets unit of First Bank St. Paul 35 years ago was that there’s no such thing as one key interest rate.
The prime rate is nice to know, maybe, but along with so many other rates it became hard to keep track. What was important, and what the bank’s veterans seemed to care about, was more the relationship between these various interest rates than what any particular bond paid in interest on a given day.
The other big idea, and maybe this was only implied, was that only a fool would try to make any sort of interest rate prediction. Let the New Yorkers try if they want to. And given how interest rate movements remain so tied to the ups and downs of the business cycle, don’t bother trying to call the timing of the next recession, either.
One of the ways these two main ideas would collide would be in those rare periods when the interest rate on the 3-month Treasury bill becomes higher than the rate on the 10-year Treasury note. That’s a phenomenon in the credit markets known as an inverted yield curve.
More than just a picayune chart interesting only to bond traders, an inverted yield curve like the one that developed recently is always carefully noted by people who care nothing for bond prices. That’s because it’s one of those famous signals that a recession may be just around the corner.
But remember, only a fool confidently forecasts the next recession.
For those banking on the continued strength of the economy, reasons for optimism are easy to find. On the other hand, there’s plenty of “tinder” to ignite a major economic bonfire, said Bryce Doty, senior vice president and senior portfolio manager with Sit Investment Associates.
But, Doty said, “what’s going to spark it?”
So instead there’s a list of worries. As this is written the latest headlines were about the Federal Reserve feeling compelled to cut interest rates, speculation over how much economic activity will be lost as the United States puts up even more trade barriers, and so on.
It’s more fun to talk about nerdy things like the yield curve than depressing topics like those.
The bond market is worth paying attention to, if for no other reason than that it’s bigger than the stock market. And it’s “often considered omniscient,” as the Leuthold Group economist and strategist Jim Paulsen put it in a recent note, although he’s obviously a bit skeptical of that.
The yield curve might be just one indicator on the dashboard of a bond investor, but it’s an important one. It gets its name by the usual shape of a line on a chart connecting a series of interest rates, or yields, paid on bonds.
Short-term T-bills almost always pay investors less than longer-term bonds, like the closely watched 10-year note, so the normal shape slopes up gently to the right.
It’s obvious why that is. Why commit money for 10 years at 2.5% when people who commit just 90 days can get the same rate? A whole lot can happen in the economy over 10 years that could cause a longer-term bond to lose value, and investors have to get paid for taking that additional risk.
But investors can also be fully aware of this risk and buy the 10-year note and keep buying, driving the interest rate down lower than very short-term T-bills. That was pretty clearly happening beginning at the end of last month. And the reason investors were doing that, and thus turning the yield curve upside down, is that they expected 10-year interest rates to decline.
An inverted yield curve isn’t what causes a recession. On the other hand, one good way to get the lower long-term interest rates that investors apparently have come to expect is to actually have a recession.
The upside down curve has been a false alarm before, of course, and it’s worth remembering that circumstances will never be the same as they were in the past. “I’ve had the same title for 23 years,” said Doty, with Sit Investment Associates. “And it’s never been the same from one year to the next.”
That’s exactly what makes recessions so difficult to forecast. There could be a whole new way of derailing the economy that triggers the next downturn. Off the top of his head Doty came up with several ways the “normal” relationship between short-term rates and longer-term interest rates could be restored overnight. Let’s say there was some peace gesture offered in the trade conflict with China, he said. That alone might be enough.
An underappreciated factor in why U.S. rates have slipped is what has happened abroad, Doty added, like with the 10-year German government bond.
The rate paid to attract investors to this German bond has been sinking like a stone and is now below zero again, a circumstance that somehow remains just as baffling as when it first happened a few years ago. For the German government, the money it can borrow for 10 years is cheaper than free.
That German bond doesn’t seem like a very smart deal for savers. But a 10-year U.S. Treasury note at 2.1% or so doesn’t seem like screaming deal, either, not when as recently as last November it paid more like 3.25%. But the larger point here is that for those who were expecting things to get back to normal, when high-quality bonds and savings accounts actually pay interest at a rate that handily beats inflation, it’s not going to happen this cycle.
Mortgage rates are back below 4% again, and the Federal Reserve certainly looks likely to cut short-term interest rates before it increases them again. So it looks like this interest rate cycle has already turned, although with interest rates that did not get close to what was considered normal before the Great Recession of the last decade.
But please don’t take this as some kind of interest rate forecast. Only a fool would go on the record with one of those.