Recession Looming? Think Again!
“The term spread — the difference between long-term and short-term interest rates — is a strikingly accurate predictor of future economic activity.”
— Michael Bauer, Federal Reserve of San Francisco
Whether you are still saving for retirement or already using your savings to generate income, you better play close attention to the bond market.
Because the spread between short-term and long-term yields is getting quite narrow.
The yield difference between 2-year and 10-year Treasury bonds narrowed to 47 points last week.
That’s the skinniest spread since October 2007, which was just a couple months prior to the start of the 2008–09 financial crisis.
Why It Matters
The way the yield curve is flattening is unusual. Usually — but not always — the 2- and 10-year bonds are moving in the same direction but at a different pace, i.e., long rates and short rates are both falling but one is falling faster than the other.
This time is different. As the accompanying chart shows, short-term rates are rising fast, but long-term rates are falling.
Source: Charlie Bilello, StockCharts.com
The 10-year Treasury yield dropped last week to 2.75%, a six-month low, while the 2-year yield has been moving higher, hitting a nine-year high at 2.3%.
Yup, short-term and long-term interest rates are moving in opposite directions.
This is important because whenever the yield curve inverts, it signals with high likelihood that our economy is going to enter a painful recession.
And don’t get me started on junk bonds. BBB-rated bonds have a negative 2.2% so far this year.
Rising interest rates and a wild stock market are not a friendly environment for junk bonds.
Inverted Curves and Recession
The yield curve is considered inverted when short-term yields are higher than long-term yields.
The yield curve isn’t inverted yet, but it is getting close. The spread between the 2- and 10-year bonds dropped to 45 basis points last week, the narrowest since the 2008–09 financial crisis.
What does that narrow spread mean to us?
As you know, the Fed raised interest rates last month, but as the above chart shows, the narrowing is coming primarily from the rise in short-term yields.
The yield at the long end of the bond market has been falling, a clear sign that large institutional interest couldn’t care less about the Fed’s interest rate hikes.
Furthermore, the drop in long-term interest rates makes dividend-paying stocks more attractive than ever. After all, where else can income-focused investors earn a decent yield?
Sure, the stock market has been on a wild ride, but until the yield curve inverts, you shouldn’t believe any of the recession talk being thrown around.
In fact, the stock market has historically done quite well when the yield curve is positively sloped, even if flattening.
Source: Bloomberg, .210 G Index, SPX Index
The historical data is clear: Stay invested in the stock market.
Here’s to growing your wealth,
Chief Income Expert, Mike Burnick’s Wealth Watch