Yield Curve and Our Durable Economy

October 26, 2018 | A Discussion the Yield Curve and other Macroeconomic Indicators

“Inflation pressures, fears of rising interest rates, and the threat of a “trade war” are just examples of how potential negatives can lead to market gyrations. We do not believe any of these negatives—together or alone—currently has the power to derail the economic expansion.”

Those were statements we made in our April 2018 letter to clients, where we addressed the 10% market correction that gripped U.S. equity markets over a two-month period, from late January through the end of March. Uncertainty was building and trade fears were running high. But we held that it would be a mistake to overestimate the potentially harmful effects of a trade war, while underestimating the robust outlook for corporate earnings, positive global economic growth trends, and the positive effects of fiscal stimulus and regulatory easing.

From the time we sent that letter through October 3 (when the current downside volatility began), the S&P 500 marched 10.7% higher. The downside volatility was unpleasant then, but it was also just temporary. Today, we believe we will see a similar outcome—the U.S. and global economy remain strong, and we believe the likelihood of a recession in the foreseeable future remains low. Four key macroeconomic indicators support our view.

The first factor is the yield curve. The chart below shows 10-year U.S. Treasury minus the 2-year U.S. Treasury, which provides a suitable but not perfect representation of the yield curve. When the line dips below zero (green circles), it is an indication that the yield curve has inverted. Once the yield curve inverts, it takes on average 17 months for an economic recession to follow.

Today, the yield curve is flattening (approaching zero), but remains upward sloping. A signal, in our view, that the expansion is maturing but not yet ending.

A look at historical S&P 500 Index returns demonstrates that stocks have also performed well in periods following a yield curve inversion but preceding a recession, an indication that a yield curve inversion is not an immediately bearish event:

The second macroeconomic indicator is comparing the U.S. GDP growth rate to the fed funds rate. Stocks tend to struggle when the cost of borrowing (fed funds rate) is higher than the GDP growth rate. Today, the fed funds rate is a range of 2% – 2.25%, with one more rate hike expected in December. Meanwhile, forecasts for third quarter real GDP average 3.8%, and fourth quarter forecasts are about 2.8%iii. Next year, growth is likely to slow as the impact of corporate tax cuts fade and as the Federal Reserve continues gradual monetary tightening, but the cost of borrowing should not exceed the economy’s growth rate.

The third indicator is the Conference Board Leading Economic Index (LEI) for the United States. The LEI measures factors like new manufacturing orders across several sectors, building permits, consumer expectations, credit, and interest rate spreads. There has not been a recession in history to start while the Conference Board LEI was high and rising, which is what we are seeing today. The chart below also shows that there is time between when LEI rolls over and when a recession takes hold:

The fourth and final macroeconomic indicator looks at bank loan activity. Bank loans are crucial to the engine of economic growth, and in the past two cycles (chart below) we’ve seen loan activity roll over about two years before an economic recession.

Bank loan activity has been solid so far in 2018, and to date we have not seen a sustained ‘rolling over’ of banks’ willingness to lend. However, as the yield curve continues to attenx with Fed rate hikes and a maturing economic cycle, banks will feel pressure on their net interest margins – making many of them less willing to lend, in our view. We’d expect to see some so softening in bank loan activity in 2019.


We believe the U.S. and global economy remain durable based on the economic fundamentals and macroeconomic indicators described above. Volatility is naturally occurring in the equity markets and is likely to continue in the coming months, but we do not believe it is indicative of the beginning of a prolonged downturn. In our view, stocks of well-managed growth companies are expected to continue reflecting improved earnings.

If you have any questions or would like to discuss any of these matters further, please do not hesitate to reach out directly.

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