2018 brought significant volatility for the fixed income markets. After four rate hikes and continued quantitative tightening from the Fed, the ten-year treasury rose from a 2.46 in January to a peak of 3.23 in November. As recessionary fears materialized alongside an inverting yield curve, global trade fears, and a flight to quality, the ten-year tumbled over 55 basis points to end the year at 2.685. High yield fixed income instruments tended to underperform, while higher quality short and intermediate durations outperformed the long end.
Review
The following table summarizes the returns for some major BofA/Merrill Lynch fixed income indices.
Is a Recession Near?
There has been considerable speculation and confusion about the economy. One market pundit thinks a recession in the near term is unavoidable, while another thinks the economy is fine. The likelihood of a recession is an important question because our research shows interest rates are primarily determined by the growth rate of the economy and inflation expectations. We are monitoring some key indicators to help us estimate the possibility of a downturn in the economy:
The Chicago Fed National Activity Index (CFNAI) is designed to be used as a leading economic indicator. It is an index composite of 85 different indicators. We prefer this index to the widely known Leading Economic Index (LEI), which only consists of 10 indicators and has a very heavy yield curve weighting. The CFNAI can forecast both potential inflation and economic downturns. When the index (after more than 2 years into an economic expansion) is higher than +0.7 we are likely to have inflationary pressures, and when it is lower than -0.7 the economy is likely to go into a recession. The chart below shows the index over the time period 1970-2018. The index is currently at +0.22. When the economy is growing at “trend” the index has a reading of 0.00. The current reading shows the economy is growing slightly better than trend, but there is little risk of inflation or recession.
An indicator in the headlines recently has been the current inverted yield curve, showing a very modest inversion with both the 2-year UST and 3- year UST trading at slightly higher yields than the 5-year UST (about 1-2 bp’s higher yield.) Yield curve inversions have occurred prior to each of the last 4 recessions. The chart below is a historical representation of these inversions. The dots show an inverted curve between 4 different spots on the curve. For example, the spread between the 10-year UST and the 3-month T-Bill and the 5-year and the 2-year UST. In past cycles, the 10-year vs 3-month inversion always took place and typically preceded a recession by about 2 years. The dots on the far-right side of the chart show the 5-year inversions, but the 10-year has not yet inverted. Speculation that the Fed will continue to tighten until we have a recession has led to increased volatility in both the fixed income and equity markets.
The difference between the yield of a 10-year UST and a 3mo UST has been shown to cause recessions during previous economic cycles when the yield curve inverts. This occurs when the yield on the shorter 3-month maturity is higher than the yield on the 10-year maturity. This is because banks borrow short and lend long. When the cost of funds for banks is higher than where they can make loans, they restrict the amount of credit they loan. The chart below shows the relationship between the steepness of the yield curve and lending standards. We use the Sr. Loan Officers Survey to measure the availability of credit. This is shown as the blue line in the chart below. This line shows the percentage of banks which are tightening credit. This index with a reading below zero shows banks are currently easing credit conditions as loans continue to be readily available. The yield curve has flattened as the Fed has raised short-term rates, but it is still slightly positive. We are monitoring credit conditions to see if lending starts to get tighter. Tighter lending standards caused by an inverse yield curve result in a negative impact on economic activity. This is well documented, and we have read several Fed papers which have studied this relationship.
Conclusion
The Fed has expressed the goal of getting the overnight Funds Rate to a level which is neither accommodative nor restrictive. We expect them to be much more cautious about further rate increases. Our work has shown the current Fed Funds rate of 2.50% today is appropriate and should be a neutral rate for the economy.