Thursday, June 28, 2018

The Yield Curve and the National Debt

By Steve Stapleton


The June 25th edition of the New York Times published an article by Matt Phillips that echoed the references in my newsletter article “Something Wicked This Way Comes” published in the June 2018 Cowles & Thomson newsletter.  Phillips’ article focused on what the yield curve may tell us.  His conclusion:  “The … yield curve is perilously close to predicting a recession.” 

On the following day, the Congressional Budget Office (CBO) released its report.  Its conclusion:  the U.S. debt will rise dramatically in the coming decades, going from 78% of GDP currently to 106% of GDP by 20391.   The consequences of a large and growing federal debt? 

  • Lower national savings and income
  • Higher interest payments, leading to large tax hikes and spending cuts
  • Decreased ability to respond to problems
  • Greater risk of a fiscal crisis

The Yield Curve

The yield curve is the difference over time between interest rates on short-term and long-term U.S. bonds.  When an economy is doing well, as common sense would tell you, the rate on the long-term bonds will be higher than the rate on short-term bonds.  The difference in the interest rate is designed to account for the risk that a robust economy could result in price increases which could trigger inflation.

Lately, however, long-term bond rates have been sluggish even though the economy generally seems to be doing well, which suggests concerns about the prospects for long-term growth.  Indeed, as the Federal Reserve has been raising short-term interest rates, the yield curve has been flattening.  On Thursday, the gap between two-year and ten-year U.S. treasury notes was 0.34 percentage points. 

When was the yield curve last at this level? 

In 2007 when the U.S. economy was about to enter into one of the worst recessions in U.S. history. 

If long-term rates continue to fall and short-term rates stay stagnant or increase, the result may be an inversion in the yield curve which is “a powerful signal of recessions,” according to John Williams, President of the New York Federal Reserve.

Harbinger of Recession?

While this is only one of many indices, it should be remembered that every recession in the past 60 years has been preceded by an inverted yield curve, according to research from the San Francisco Federal Reserve.  Yield curve inversions have “correctly signaled all nine recessions since 1955,” according to the Fed’s researchers’ March 2018 report.  Notably, a yield curve inversion occurred in February 2000 just before the dot-com bubble burst.

A flattening yield curve makes banking less profitable and, if the curve inverts, it will adversely affect lending activity generally.

Other signs are out there:  the S&P 500-stock index is in negative annual territory after peaking on January 26, corporate bond returns are running negative, some industrial commodity prices are down.  Indeed, the CBO Report puts the economic prospects somewhat starkly.

What Next?

So what do you do?  The answer is simple.  Plan for it. 

Consider a report from McKinsey several years ago: the worst-performing companies used a good economy to expand, acquiring other companies and taking on debt.  In a downturn, these same companies sold divisions or brands and struggled to pay down their accumulated debt.

And, while the United States seems to be operating like a worst-performing company (dramatically expanding its debt in good times), the best-run companies did exactly the opposite: they used the booming economy to strengthen their financial resiliency; they paid down debt and resisted the urge to expand.  In the downturn, they used their financial strength to buy up their competitors.

Boom and bust.  It’s all cyclical.  Those who plan for it, thrive.  Those who fail to plan for it, don’t.  Like I said, the answer is simple.

1. The last time the national debt was this high was in 1946, immediately after World War II.

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