Peter Donisanu is an Investment Strategy Analyst at Wells Fargo Investment Institute, and Dr. Brian Jacobsen is a Senior Investment Strategist on the Multi-Asset Solutions Team of Wells Fargo Asset Management.

Rising short-term rates and a flattening yield curve in the U.S. bond market have some investors asking whether the U.S. economy is headed for a recession in 2018 – and for good reason. Since 1978, the U.S. has had five recessions, and each one was preceded by an inverted yield curve. The yield curve inverts when short-term rates move above long-term rates. Currently, however, the yield curve is flattening, not inverting. There’s a big distance between an upward-sloping yield curve and a downward-sloping (inverted) yield curve. It really shouldn’t surprise anyone that the yield curve—as measured by the yield on the 10-year U.S. Treasury note and the 2-year U.S. Treasury note—is flattening. In fact, it is flattening at nearly the exact same pace as it has during previous periods when the Federal Reserve (Fed) was hiking rates.

Just like in previous hiking cycles, for every increase in the federal funds rate, there was approximately the same reduction in the slope of the yield curve. Simply extrapolating out from the current path of rate hikes suggests we could get a flat yield curve when the target federal funds rate hits 3.35%.

Source: Bloomberg and Wells Fargo Asset Management

In the above chart, Fed hikes are shown by scanning from the left to the right. We fit straight lines to the chart to show the comparison of the hiking cycles. In the equations, “y” is the slope of the yield curve (10-year yield minus 2-year yield) and “x” is the target for the federal funds rate. These lines are nearly parallel, showing that just like in previous hiking cycles, for every increase in the federal funds rate, there was approximately the same reduction in the slope of the yield curve. Simply extrapolating out from the current path of rate hikes suggests we could get a flat yield curve when the target federal funds rate hits 3.35%. Based on the current (April 2018) Summary of Economic Projections from the Fed, the Federal Reserve thinks it will get to a target rate of around 2.8% to 2.9%, meaning it plans on stopping just before the yield curve flattens.

What could lead to an inverted yield curve and a potential recession?
A few patterns tend to coincide with an inverted yield curve that foreshadows a downturn in the U.S. economy. First, rising rates of inflation (measured both by the headline core Consumer Price Index (CPI) basket and core Personal Consumption Expenditures (PCE) index) tend to track the yield curve’s progression into negative territory. Second, the Fed has typically increased its benchmark rate at a notable pace to address rising prices. Given the absence of significant inflation pressures, we could also see the curve invert should the Fed make a policy mistake by increasing short-term rates in the absence of these factors.

There have been times in which the yield curve inverted but a recession did not follow.

Source: Bloomberg, Wells Fargo Investment Institute; 4/18/18

While an inverted yield curve has typically been a good forward-looking indicator of a recession, it is not perfect. The chart above shows that there have been times in which the yield curve inverted but a recession did not follow.

How do today’s developments compare with historical pre-recession periods?
In the past five economic cycles, the Fed hiked rates an average of 180 basis points (bps; 100 bps equal 1.00%) in the 12 months leading up to prior curve inversions. Similarly, core CPI and PCE inflation rates rose by an average 0.8% and 0.7% percentage points (respectively) over the same period of time. This is quite notable when compared to the past twelve months; over that time period, the Fed has increased rates by only 75 basis points, while the percentage point change in core PCE is near zero and core CPI negative. From this vantage point, trends in inflation and Fed policy have yet to signal an impending yield curve inversion.

While the threat of an inverted yield curve is disconcerting to some investors, the Wells Fargo Investment Institute does not expect curve inversion in the near term. We look for inflation to increase at a modest pace throughout 2018, allowing policymakers at the Fed to continue to raise rates at a steady pace. At this point we do not think investors should be overly concerned with a flattening but not yet flat interest rate curve and even less concerned that a recession is imminent.

 

The WFAM MAST view, by Brian Jacobsen: Implications for investors

The Wells Fargo Multi-Asset Solutions Team’s view of how this will play out is that the yield curve still has a ways to go before it sends an early warning sign that the growth outlook is deteriorating. That’s important to us as we believe asset returns are driven by surprises to growth, rates, and inflation.

  • If the consensus view is coalescing around the idea that growth is faltering, then that potentially leaves room for upside surprises to growth. We look at the world through the lens of risk premia—the expected returns to being exposed to risks—and it suggests to us that we can be comfortable maintaining an overweight exposure to the economic growth risk premium. That translates into us being overweight equities and credit.
  • However, because the Fed is still on course to keep hiking rates, we see little value in overweighting a term risk premium and therefore have underweighted intermediate to longer-dated government bonds.
  • The Fed’s vigilance and insistence on normalizing monetary policy should probably keep inflation under wraps. For us, that means we’re not too worried about any inflation scares. Inflation scares can cause long-term government bond yields to rise abruptly; so, for us, while we don’t like longer-dated government bonds, we see good value in old-fashioned security selection in the investment grade corporate bond and high yield bond space.

 

Risks:

Although Treasuries are considered free from credit risk they are subject to other types of risks.  These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate.

The views expressed and any forward-looking statements are as of the date indicated and are those of the author, Brian Jacobsen. Discussions of individual securities, or the markets generally, or any Wells Fargo Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

Wells Fargo Investment Institute, Inc. (”WFII”) is a registered investment adviser and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

Opinions represent WFII’s’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. WFII does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. WFAM includes but is not limited to Analytic Investors, LLC; ECM Asset Management Ltd.; Galliard Capital Management, Inc.; The Rock Creek Group, LP; Wells Capital Management Inc.; Wells Fargo Asset Management (International), LLC; Wells Fargo Asset Management Luxembourg S.A.; Wells Fargo Funds Distributor, LLC; and Wells Fargo Funds Management, LLC. Wells Capital Management is a registered investment adviser that provides investment management services for a variety of institutions. Wells Fargo Funds Distributor, LLC, Member FINRA, is a limited-purpose broker/dealer that distributes certain investments. This material is for educational/ informational purposes only and should not be considered as investment advice or a recommendation for any particular security, strategy, or investment product.

 

 

 

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