What are interest rates telling us about the current state of the economy? And, more importantly for investors, what are they telling us about the markets?
A few weeks back Ben Carlson had a good post addressing the first question. He asks what interest rates (specifically the spread between 2-year Treasury yields and 10-year Treasury yields) are telling us about the likelihood for a recession. Here's Ben:
When the 10-year yield falls below that on 2-year treasuries it’s called an inverted yield curve, and Ben writes:
You can see that every single time that 10 year yields have fallen below 2 year yields it has preceded a recession (the shaded regions). This data only goes back to the late-1970s but is impressive nonetheless.
Next, he correctly points out that just because something is a reliable historical indicator, to expect it to work in the future, there must be a sound, fundamental explanation of why. Again from Ben:
In this case there is a logical reason for using the yield curve as an economic signal. Bond yield spreads are typically used to gauge the health of the economy. Wider spreads between long-term and short-term bonds lead to an upward sloping yield curve, which can indicate healthy economic prospects — most likely higher growth and inflation in the future. Narrower spreads lead to a flatter or even negatively sloped yield curve, which can indicate poor economic prospects — most likely lower growth and inflation.
His accurate conclusion is that we should pay attention to this indicator. We aren't yet at an inverted yield curve with the current spread around .80%, but, with the spread falling, it is worth watching.
However, I was left wondering about the second question. What do interest rates and the yield curve mean for the markets (as opposed to the economy) going forward? If an inverted yield curve means a recession, that’s probably pretty bad for stocks, right? Well, not quite. Let’s take a look.