Is There a Crystal Ball Out There?
Recently, the pivot in our news cycles has been toward a topic that impacts everyone: recession. While the energy level around the threat of a pending recession is very high, there is a historical, empirical indicator out there that should raise our antennae. That indicator is the yield curve.
To begin, let’s look at what the yield curve is. In its simplest form, the yield curve is a comparison of short-term interest rates to long-term interest rates. While there can be disagreement as to what constitutes short-term and long-term rates, for our purposes we will consider short-term to be 30-day Treasury bills and long-term to be 10-year Treasury notes. The normal state of affairs is that short-term rates are less than long-term rates, as investors typically will expect to receive a premium for investing dollars for a longer period. While long-term rates are generally set by supply and demand economics, short-term rates typically track the Fed Funds rate, which is set by bureaucrats at the Federal Reserve. When the yield curve inverts, long-term rates are lower than short-term rates which is considered an “unnatural state.” The yield curve has been flattening for some time, but first became inverted in May 2019 prior to the most recent reduction in the Fed Fund rate on July 31, 2019. As of August 12, 2019, the 30-day T-bill rate was 2.09% and the 10-year bond rate hit a three-year low of 1.65%. Inversions generally happen when investors believe that a recession or slowdown is coming and “go to safety” in 10-year notes. As mentioned previously, since these rates are set by supply and demand, the greater the demand, the lower the yield.
What is the correlation between an inverted yield curve and a recession? Since 1962, there have been 9 instances where the yield curve was inverted. In seven of those instances, a recession followed with an average lag time of 14 months. The average recession lasted 18 months. So, can we predict with certainty that we should expect a recession in 2020? No!
Part of the reason for being somewhat skeptical is looking at how we got to the current situation. On the short-term side, the Federal Reserve reacted aggressively in raising short-term interest rates three times in 2017 from 0.75% in January to 1.5% in December and an additional four times in 2018 to 2.5% to keep the economy from becoming overheated and leading to “runaway” inflation. The economy has shown strong growth and low unemployment and good wage growth without strong indicators of inflation. This resulted in the Fed reducing the Fed Funds rate the end of July 2019 to 2.25%. Because of the ongoing tensions as it relates to trade negotiations with China (and others), investors were nervous about near-term economic prospects and went to the safety of long-term notes. However, additional demand for the safe-haven of U.S bonds is that several of the United States’ key trading partners have negative 10-year interest rates including Japan (0.27%), German (0.72%), France (0.44%), Netherlands (0.57%) and Switzerland (1.05%). Additionally, historic interventions in money markets by central banks in the U.S. and Europe following the last recession have created a new set of dynamics that make it harder to predict the impact on future growth and profits.
The Federal Reserve Bank of Cleveland graphed the probability of recession going back to 1960 using a “univariate probit model.” This is a rather complex formula that explains the probability of recession any point in time 1 to 4 quarters out using the 10-year minus 3-month term spread as the variable. Over the period from 1960, the historical probability of recession using this model was at least 30% (1960) and generally in the 40% to 60% range. Using this model, the current probability is around 15%.
What impact might the inverted yield curve have on the banking/lending industry? In general, this is not a good situation for lending institutions as banks and credit unions pay short-term on deposits and get long-terms rates on loans. The result over the longer term could lead to a weaker or declining net interest margin. Smaller institutions (i.e. less than $1 billion) are likely to be more effected as they typically have a less diversified franchise and more heavily reliant on interest income than large institutions with a greater percentage of income from non-interest sources. Asset-sensitive lending institutions (those that have a heavily weighted business portfolio) are also more sensitive to reducing yields as the business loans tend to be on floating rates. If there is a recession or slowdown, the Federal Reserve would likely reduce short-term rates to spark business activity, which means falling interest income as well. Given that rates paid to depositors is already near rock bottom, there is little opportunity to hold or increase interest margins.
From a credit quality perspective, this might be a good time for lenders to critically evaluate their loan portfolios. A critical evaluation of a marginal borrowers’ ability to weather a downturn or recession would need to be front of mind. For higher quality credits, looking for opportunities to enhance your yields through fee-based business and/or creative laddering of interest rate maturities may be helpful in insulating yields to coming changes.
At the end of the day, we do not have a crystal ball to tell us what is going to happen. There are certainly some cautionary indicators present but given the strength and diversity of the total U.S economy, I would refrain from jumping on the “sky is falling” bandwagon. Just turn off the TV! It is amazing how much better you will feel!
Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape, and lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133