The Yield Curve

The return of the inverted yield curve has set the market on edge this week as it’s a strong—if not the best—predictor of an economic slowdown.

March 25, 2019

Hitting the (inverted) curve

If the Fed was trying to avoid inverting the yield curve, ironically, their plan backfired. At last week’s meeting, the Fed struck an even more dovish stance than expected – it further reduced the projected pace of rate increases and indicated that it would start winding down balance sheet normalization in May, ceasing entirely in September. The Fed cited a weakening outlook for the U.S. economy. Treasury yields fell in response with the yield curve flattening, but the equity market largely cheered the result.  On Friday, after weak PMI readings from Germany and the Eurozone, German bond yields turned negative for the first time since 2016. The equity market, no longer fully ignorant of the slowdown the Fed cited just two days prior, reacted negatively. And the yield curve in the U.S. inverted for the first time since 2007, with the yield on 10-year Treasury bonds falling below 3-month Treasury bills.

An inverted yield curve remains one of, if not the best, predictors of recessions

An inverted yield curve remains one of, if not the best, predictors of recessions despite being imperfect and imprecise in timing. It correctly predicted the last 7 recessions, with only one false positive in 1966 when the Fed quickly moved to lower rates. Once the 10-year/3-month curve inverts for about ten consecutive days a recession emerges on average roughly 300 days later. But this lag between an inverted yield curve and a recession varies from as short as about 6 months to as long as about 16 months. We have not yet reached that 10-day threshold. We think that while predicting recessions remains a fool’s errand, our proprietary macroeconometric model has consistently cited late 2020 into 2021 as the period with the highest risk of a recession. Our model generally agrees with the timeline now set by the inverted yield curve. The economy is unequivocally slowing as we predicted. Averting a recession and engineering a “soft landing” will almost certainly become more challenging now that markets have turned dourer. This could potentially impact corporate and consumer behavior and create a self-fulfilling prophecy.

Unemployment stands near half-century lows and the number of open jobs sits just below the all-time high at 7.6 million.

Other economic data continues to show strength, though that also occurred during previous cycles. With the curve inverted, our focus now fully turns to the labor market. Unemployment stands near half-century lows and the number of open jobs sits just below the all-time high at 7.6 million. Any disruptions in the economy will likely materialize in the labor market before showing up in economic growth measures. We will closely monitor both the unemployment rate and weekly initial unemployment claims. When the unemployment rate rises roughly 50 basis points from its cyclical low that also strongly signals a recession. But before that occurs we will likely see an uptick in weekly claims - which have increased slightly in recent periods. 

Additionally, the inverted yield curve likely indicates that Fed tightening has ended for this cycle. In the most recent Fed forecast, one rate hike in 2020 remains, but we have little confidence in that given the Fed’s recent abrupt reversal on further rate hikes. That leaves the fed funds rate, in the 225-250 basis point range, well below the peak level from previous cycles. Even if the Fed manages one more rate hike of 25 basis points, we will remain far below the previous cyclical peak level. This will provide the Fed with significantly less fodder to blunt the impact of the next recession whenever it arrives. For context, the Fed had more than 500 basis points to cut heading into the Great Recession, so they now have less than that amount. If the Fed decides to cut rates before the next recession emerges, they could potentially have even less runway.

What we are watching this week

Of course, we will closely watch the yield curve to see if it remains inverted. Additionally, as many important data points are slated for release, the markets will look for any sign of direction in the economy. Consumer confidence and sentiment for March should hold steady, supported by a tight labor market and accelerating wage growth. Personal income in February and personal spending in January likely rebounded after a weak December. We expect modest upward pressure on the headline and core personal consumption expenditures (PCE) inflation indexes for January. We foresee little change to housing starts and building permits for February. We also look for a significant downward revision to fourth quarter’s GDP growth in the final estimate led by weaker than estimated construction spending and retail sales data.

What it means for CRE

We avoid getting hung up on whether a recession is coming. A pronounced slowdown in the economy, with or without a technical recession, would likely impact commercial real estate (CRE) negatively. The most direct channel would be via slowing rent growth and vacancy compression. This would likely occur across property types. Secondarily, a slowdown could impact investor appetite, eventually translating into higher cap rates. Higher-beta property types, such as hotel, office, and retail, would likely see greater impact than more defensive property types such as industrial and apartment. Across property types, the emphasis should increasingly turn toward the merits of the individual deals without the rising tide of the overall economy to support the CRE market.

Thought of the week

According to recent research, U.S. consumers have borne the full brunt of the U.S. tariffs on imported goods.

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