Predicting the Future
Want to know what may be in store for the U.S. economy and, ultimately, your wallet? Watch the ever-changing relationship between various interest rates. Since you have better things to do than watch the spread between the 2 year and 10 year Treasury, we do that for you. Nevertheless, you can better understand where the economy may be headed by watching interest rates.
At present, short-term interest rates are about the same as long-term interest rates. For example, a 30-year Treasury bond earns 2.9% while the 90-day Treasury note earns 2.4%. An investor receives a paltry 0.5% for an additional 29.75 years.
Some longer-term rates have recently exceeded shorter-term rates. This phenomenon is called the inversion of the yield curve and has been 100% accurate in predicting recessions in the past. Could this time be different than every other time in the past?
Probably. The first indicator that a recession is unlikely can be found in the interest rates paid by high yield debt issuers. If economic times are expected to become weaker, heavily indebted companies are typically the first to get into financial trouble. Bondholders know this and as a result, borrowing costs go up for these riskier companies relative to Treasuries. So far, the high yield debt market is performing exceptionally well and at some of the smallest spreads over Treasuries in history. If we see a widening of the spread, that would be an early indicator that bigger problems may be ahead. Additionally, interest rates would have to invert by 0.5% to 0.9% to provide a signal that a recession is inevitable. Where the 30-year Treasury is at 2.9% at present, the 90-day Treasury would need to be at least 3.4% or 1% higher. Given that the Federal Reserve seems unlikely to raise short-term rates any time soon, there is no obvious path to higher short-term interest rates.
If history is an indicator, once clear recessionary signals are present, the stock market typically continues to go up for another year or two before stock prices begin to reflect revised expectations.