What advisers should tell clients about the inverted yield curve

Some things seem so abnormal that people take them as omens of doom. For example, if the furnace shouts, “Get out!” every time you go into the basement, you might assume that your house wasn’t such a bargain after all. And if the yield on the two-year Treasury note is higher than the yield on the 10-year note, you might assume that the stock market and the economy are in for tough times.

In the normal course of events, of course, furnaces rarely shout, much less murmur, and short-term notes typically yield less than long-term notes. Investors want bigger rewards for lending money for 10 years than two years. A lot can happen in 10 years, after all. So when the two-year T-note yields more than the 10-year T-note — a condition called an inverted yield curve — Wall Street pays attention.

An inverted yield curve can mean that the Federal Reserve is aggressively pushing up short-term rates, which results in a cooler economy at best and a recession at worst.

In fact, an inverted yield curve is one of the better recession indicators around. A recession typically follows an inverted yield curve within 12 months, although the short end needs to be about 0.6 percentage point higher than the long end to make a definitive signal, according to Sam Stovall, chief investment strategist of U.S. equity strategy at CFRA.

The yield curve isn’t inverted now, but it’s close: The two-year T-note is only about 0.45 percentage points lower than the 10-year yield. The spread between the two Treasury notes hasn’t been this tight since October 2007.

What’s particularly troubling about the current state of the yield curve is that the Federal Reserve is tightening monetary policy on two fronts: Not only has it been pushing up its key fed funds rate, but it has been selling off the bonds it bought during its rounds of quantitative easing.

“It will be interesting if, despite the Fed’s passive reduction of its bond holdings, we find that long-term yields are not rising enough to prevent an inverted yield curve,” said John Lonski, team managing director of the economics group at Moody’s Analytics.

What are the odds the yield curve will invert? “I don’t think there’s a better than 50-50 chance,” said Kim Rupert, managing director of fixed-income analysis at Action Economics. After all, corporate earnings are strong — so far this earnings season, 265 companies in the S&P 500 have reported earnings, with 75% showing double-digit or better year-over-year growth, according to S&P Global Market Intelligence. Ten companies have exceeded 100% growth.

Few other indicators are flashing red. Consumer confidence remains high, for example, and the Conference Board’s Leading Economic Indicators rose a healthy 0.3% in March.

The real danger is that the Federal Reserve will become too aggressive in raising short-term rates, but Ms. Rupert doubts that will happen.

“The Federal Open Market Committee in general remains on very cautious footing,” she said.

Others are not so sure: Monetary policy isn’t an exact science and while there are whiffs of inflation in the air, raising the fed funds rate too far, too fast could spell serious trouble for corporate borrowers, the housing market and the stock market.

“It’s one thing to get ahead of the curve and hit the ball, and another to swing so early you strike out,” Mr. Lonski said.

The top of the fed funds range stands at 1.75%, and fed fund futures put the odds of it hitting 2.25% or higher by the end of this year at roughly 85%, according to a recent commentary from Thornburg Investment Management. And that may be the biggest headwind that clients face.

While the long-term bond market isn’t controlled directly by the Fed, it certainly hasn’t been a happy place recently. The average intermediate-term bond fund has fallen 1.94% so far this year, and the average long-term government bond fund is down 5.56%, including reinvested dividends.

Rising rates have also given the stock market the jitters. The yield on the 10-year T-note is now substantially higher than the yield on the S&P 500, which stands at 1.97%.

More importantly, short-term rates are starting to look appealing. According to BankRate.com, the top-yielding one-year bank certificate of deposit — via Goldman Sachs Bank USA — sports a 2.2% yield, and a one-year T-bill yields 2.24%.

People who bought dividend-producing stocks for income now find them less attractive: Utility stocks, for example, have shed 0.9% this year, including dividends. Telecom stocks, consumer staples stocks and real estate also tend to be laggards when rates are rising.

The key takeaways for investors:

• Long-suffering savers can finally get a bit of return from their investments. Currently, one of the best places for savers and income investors is the Treasury’s two-year floating-rate note, said Kevin Flanagan, senior fixed-income strategist at WisdomTree. The rate resets at the weekly 13-week T-bill auction, not only offering investors a rate hedge for their portfolios, but also providing the opportunity for an enhanced yield.

• Dividend-paying stocks will lag as rates rise. The average dividend-paying stock in the S&P 500 has lost 1.02% this year, versus 2.86% for the average non-payer. This could mean that there are some relative bargains among large dividend payers: 117 stocks in the S&P 500 have yields higher than 3%. Those include names like PepsiCo (3.25%), MetLife (3.55%) and Pfizer (3.84%).

• Both the yield curve and the fed funds rate bear watching, but they aren’t in the danger zone yet. Historically, when the yield on the S&P 500 has come within one percentage point of the 10-year Treasury note yield, the blue-chip index has risen 11% in the following 12-month period, Mr. Stovall said.

“The wider that becomes, the less attractive stocks are,” he said. “But historically, the yield on the 10-year has to rise above 6% before the average monthly change in the S&P 500 goes negative.”

In short, the yield curve — and rates generally — are flashing yellow right now, but not red. The big question is whether the Fed goes too far in raising rates.

“The ball is in their court,” Mr. Lonski said.

Related Topics: Federal Reserve