Feb 06, 2017

The Yield Curve: A Bit More Growth Now, A Bit Less Later

By Gene Balas

In economics, as with many things in life, there's a long run view, and there's what happens in the near term. Individual forecasters may try to predict GDP growth in the next year or two, and sometimes they're right, sometimes they're not. Then there are market-based estimates that compile the views of legions of investors, which are incorporated in market prices. We can see this in simple display in equity prices, which are oftentimes a reflection of a company's earnings in the future. In contrast to this highly specific view, the bond market offers a glimpse into what investors believe will happen to the entire economy in the future, and in some cases, far into the distant future. And what the yield curve tells us is that, after the election, investors see a bump to growth in the near term, given growth-friendly policies and stimulus, but that these effects fade over the long term.

Long run economic growth rates are beyond any government's control

In many instances, many economic forces are simply beyond the control of a single company's intention to grow its earnings or politicians' desire to pass growth-friendly laws. Long term growth of an economy is influenced by two basic factors: how many people are working (and how many hours they work), and how much they produce each hour. In other words, the long run growth rate of an economy is simply growth of the labor force plus productivity gains.

In the short term, perhaps economic policies by governments can affect the growth rate of the economy, such as to make working more financially rewarding (thus drawing in more people to the labor force), or by affecting the incentives for companies to invest in productivity-enhancing technologies or equipment. What we see in the case of the election of the Trump administration is that markets do see a bump higher in short term growth.

Examining how the yield curve "predicts" economic conditions

First, though, before we get into the details, we'll cover some of the basic groundwork of the signals the yield curve provides. The steepness or flatness of the yield curve is an indication of how fast the economy might grow, and how much inflation it might produce (thereby requiring higher short term rates in the future). The steeper the yield curve, the more investors expect inflation and interest rates to rise in the future, and the more yield they demand for holding longer term bonds. When the yield curve flattens (or even inverts, where short term rates are higher than long term rates), then investors expect a slowing economy. Central bank bond buying programs also exert an influence as well, of course.

Let's take a look at the relationship between the yield curve and the economic cycle, where we use the difference between the 10-year Treasury yield minus the 2-year Treasury yield as the measure of the shorter-term steepness of the yield curve. Because this is a leading indicator, we'll move ahead this measure by nine quarters and compare it to actual economic growth, measured by real GDP. As seen in the nearby graph, there is a relationship between the two.

Yield Curve and Economic Growth.png

The near term vs. the long term view

Having established there is some relationship between the two variables, now let's compare the measure of the steepness in the yield curve in the short and intermediate term (the 10-year Treasury yield minus the 2-year Treasury yield) and the longer term (the 30-year Treasury yield minus the 10-year Treasury yield). Note the big jump in the steepness of the former after the election, when investors forecast more growth and inflation with the new administration. But a curious thing happened with the longer term part of the yield curve: it flattened, with investors expecting a bit less growth and inflation.

Long Term vs Short Term Yield Curve Spreads.png

What gives? Well, for one, no politician can increase the fertility rate, and absent any changes to immigration policy, the growth of the labor force is expected to slow. We've also seen many of the gains from new technologies already incorporated into business practices, though we don't know what the next big new thing will be in the future. As such, the general thinking of economists is that we'll face growth that can't change much over time, as seen in the nearby graph indicating real potential GDP, forecast far into the future. Investors agree, as indicated by the relative flatness of the longer portion of the yield curve. Any fiscal stimulus now will eventually need to be paid back through higher tax revenues or spending cuts later, so unless growth improves dramatically, fiscal stimulus now can turn into a fiscal drag later.

Real Potential GDP (1).png

You'll note that potential GDP tops out at a bit less than 2%. Given that the labor force is expected to grow by 0.5% annually between now and 2024, according to the Bureau of Labor Statistics, and that productivity gains are expected to be around 1% or so, according to the Federal Reserve Bank of San Francisco, perhaps this long term growth rate is about what we can realistically expect. The yield curve, it turns out, reflects the collective wisdom of millions of investors. Given the strong relationship it has had in foretelling economic booms and busts in years past, perhaps we might respect its signals.

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