(PUB) Investing 2016

Today’s Yield Curve

Yield Spreads at Pre-Crisis Levels? Panic!

Yield Spreads Need to Invert to Flash Yellow

2.5%

3.0%

4.0%

2.0%

3.0%

2.5%

2.0%

1.5%

2.0%

1.0%

1.0%

1.5%

0.0%

1.0%

0.5%

-1.0%

0.5%

Yield Spread Recession

Yield Spread Recession

-2.0%

0.0%

Diff. in 10-Yr and 2-Yr Treasury Yields 0.0%

-3.0% Diff. in 10-Yr and 2-Yr Treasury Yields

7/16

7/21

7/26 Maturity Date 7/31

7/36

7/41

7/46

6/08

6/09

6/10

6/11

6/12

6/13

6/14

6/15

6/16

6/80

6/84

6/88

6/92

6/96

6/00

6/04

6/08

6/12

6/16

stock markets were poised to be cut in half. Take note that the yield-curve story making the rounds today is being framed to raise your alarm bells. But does it really signal the onset of another recession and bear market? I don’t think so. Let’s step back and take a broader historical perspective than one focused solely on the last recession. The graph on the right shows the spread between 10-year and 2-year Treasury yields back to 500 Index ’s inception in September 1976 (we’ll tie in the stock market in a moment) and highlights recessions in grey bars. The reality is that the yield curve isn’t very helpful in predicting recessions until the 10-year yield falls below that of the 2-year—a fairly rare situation referred to as an “inverted yield curve” in market lingo. And note that an inverted yield curve (when the blue line falls below zero) can be an early warning sign, but is definitely not an immediate trigger or sign of a nearby recession. Yes, the spread between the 10-year and the 2-year Treasury was last below 1% just before the Great Recession. But at that time the yield curve was steep- ening from an inverted level. It wasn’t

money sitting in checking and savings accounts doesn’t just sit there, though. The bank then lends that money out at long-term rates (for instance, in the form of a 30-year mortgage). The steeper the yield curve (long rates yielding more than short rates), the greater the profit the bank makes on its loans and the more likely they are to lend, which spurs economic activity. If the yield curve is not very steep, then banks are less inclined to lend, and economic growth is stunted. So, as I said at the outset, the shape of the yield curve has some bond mar- ket watchers concerned that a reces- sion is fast approaching. What has sparked the current worry is the fact that the difference between 10-year and 2-year Treasury yields has been shrinking—the yield curve has been flattening dramatically. Today, with the 10-year Treasury yielding 1.46% and the 2-year yielding 0.66%, the spread is just 0.80%. The “flat-landers” are focusing on a chart similar to the middle one above, which plots the dif- ference in 10-year and 2-year Treasury yields, to highlight the fact that the last time the yield curve was this flat was in late 2007 and early 2008, when the economy was headed for recession and

coming down from a steep level, as it is doing today. Looking further back, you’ll see the Treasury market spent much of the late 1990s with the yield curve well below 1%, but it wasn’t until the curve invert- ed that the U.S. was on the verge of a recession. The same could be said for the 2008 recession, as well as the 1979,

Contrary to the headlines, today’s yield curve suggests we are in the sweet spot for strong stock market returns.

1981 and 1991 recessions. In fact, the time between the yield curve’s inver- sion and the ensuing recession ranged from 11 months to 19 months for the five recessions we’ve experienced over the past 40 years. So, I’d posit that today’s flattening yield curve is not a harbinger of a reces- sion—yet. But doesn’t the sheer fact that a flat yield curve could lead to an inverted one mean that a recession and a stock market decline are just around the cor- ner? Contrary to the cautionary tone struck by many bond market mavens, today’s yield curve suggests we are actually in the sweet spot for strong stock market returns going forward. My colleague atAdviser Investments Brian Mackey (who initially shined

The Sweet Spot for Stocks

SPREAD BETWEEN 10-YEAR AND 2-YEAR TREASURY YIELDS

Full Time Period

<0% 0%–1% >1% 16% 36% 48%

% of Time

100%

Avg. Return of 500 Index Over Next 12 Months Frequency of Loss Over Next 12 Months

9.0% 16.2% 10.5% 12.3%

36% 16% 17%

20%

SEE WRONG PAGE 16

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The Independent Adviser for Vanguard Investors • August 2016 • 7

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