The U.S. Yield Curve Is Sending the Right Signals

When it comes to assessing the outlook for the U.S. economy these days, the discussion usually starts with the bond market’s yield curve. At less than 30 basis points, the difference between two- and 10-year Treasury yields is the narrowest since 2007.

This is classic late-cycle behavior. The curve is signaling that the market thinks the Federal Reserve’s interest-rate increases, which are driving short-term yields higher, will not only slow inflation, but could also tip the economy into recession, causing long-term yields to go nowhere or even fall. The point is that the yield curve is not just a signal, but something that could actually weigh on the economy. Why? Because higher short-term rates make adjustable-rate loans more expensive and lower long-term rates eat into the profitability of banks, which tends to lead to lending restraint.

A recent Economic Letter from the Federal Reserve Bank of Dallas made note of this in a paper titled “Smaller Banks Less Able to Withstand Flattening Yield Curve”:

For the overall U.S. banking system, the effect on profitability of yield-curve flattening … lasts about a year and is relatively small. After the first year, the impact on large banks’ profitability becomes positive; for smaller institutions, it stays negative and becomes larger. Recent yield-curve flattening is likely to more strongly affect smaller banks, reducing their profitability.

Here are eight more reasons to be worried about the economy:

Trade wars. So much has been said that it’s hard to add to the discussion, other than to say when you have the likes of General Motors Co. warning of job losses; U.S. farmers up in arms; and just about every economist, non-Trump administration politician, and a vast majority of CEOs opining the same way; it’s worth taking notice. Think of the impact on investment. Tariffs will lead to some self-imposed inflation, a more aggressive Fed and job losses, which seems like a reasonable set of recessionary pre-conditions.

High equity valuations. To the extent the stock market is a proxy of economic sentiment, any shift in allocations in favor of, say, bonds will take its toll. At the levels where stocks are currently trading, selling often begets selling as investors “strategically” rebalance.

Politics in the U.S. and abroad. Nationalism, changing political agendas, and disruptions to norms heighten uncertainty, which inhibits risk-taking. I don’t know how this all transpires, but we have midterm U.S. elections coming, a Brexit, murmurs from Italy about leaving the European Union, and a host of other global political risks.

The Fed. The U.S. central bank is intent on raising rates three or four times in the next year, which has bullish implications for the dollar and bearish ones for emerging markets, as we’re seeing. The weakness in the yuan suggests that’s China’s big weapon against higher U.S. rates and tariffs, but it does have negative implications for China’s stock market and other Asian markets. This harks back to an equity correction.

Hawkish central banks. The Fed isn’t the only central bank pulling back the punch bowl. It would be disingenuous to negate their impact on holding rates low following the financial crisis, helping to boost risk assets. So, expect the unwinding of easy money policies to have the opposite effect. Newton’s third law says that for every action there is an equal and opposite reaction.

Corporate debt. At 45.4% of gross domestic product, it’s pretty much the highest ever, and yield spreads are starting to widen in a sign of investor pushback. Recall that corporate debt was also near 45% of GDP preceding the last two recessions. Higher corporate borrowing costs will inhibit share buybacks that have helped fuel the equity rally in recent years.

Tax stimulus. The consensus is that tax reform was front-loaded and will begin to peter out by 2020, leaving a bulging federal budget deficit that needs financing at the same time the Fed will stop reinvesting the proceeds of its maturing bond holdings into new securities. And if we’re at the best point of the cycle for those corporate tax cuts to be working, why isn’t the stock market doing better even though second-quarter GDP is tracking at about a 4% rate?

It’s been a long recovery. Some say recoveries don’t die of old age, but the rest of us do. The longer this recovery goes on and the longer equities trade sideways, the more anxious businesses will get about expanding and the itchier investors will get about taking profits. It’s well-known that corporate America is using its excess cash for buybacks, dividends and acquisitions rather than organic investment. That’s a telltale signal executives are not so confident in growth, which inevitably brings me back to our budget deficit and the ultimate need to, somehow, pay for it.