The Yield Curve Is Tightening, but There’s More to the Story

Despite growing fears that the Russia-Ukraine war is turning into a quagmire and concerns about persistent inflation and rising interest rates, the stock market turned in its second winning week in a row. The S&P 500 Index, in fact, has more than made up for losses due to the war. In its traditional role as a leading indicator, the market may be signaling that despite the current gloom, better days are coming.

That said, we may in the coming weeks and months start to hear chatter about a yield curve inversion. The inversion of the yield curve is often considered a signal of impending recession because it reflects concerns about the present and negative views of the future. But there may be more to the current story.

There have been major moves in the bond market this year. Yields on two-year U.S. Treasury bonds are up more than threefold since the start of the year, to 2.3 percent. Meanwhile, prices on the longer-term 10-year Treasury bond yields rose almost 100 basis points this year and briefly touched 2.5 percent this past Friday. That put the difference in yield between the 10-year and two-year Treasuries at just 20 basis points, which is the smallest difference between the two since the summer of 2019, right before shorter-term yields rose above longer-term yields and the Fed started to cut interest rates.

It’s important to note, however, that there are other yield curves and that those curves historically have inverted alongside the 2s/10s curve. But they are telling a different story today. For example, there is the relationship between three-month Treasury notes and the two-year bond. That curve has been steepening dramatically since last fall and is now near 20-year highs in steepness, which means that investors are less worried about the present and see better economic conditions ahead, albeit with higher inflation.

Whether or not an inversion occurs, we continue to be optimistic that the U.S. economy will grow over the intermediate term. Such growth leads to positive equity returns with fairly high levels of consistency.

Wall Street wrap

The Fed talks tough. After raising the key fed funds rate by 0.25 percent the week earlier, Federal Reserve Chairman Jerome H. Powell addressed the National Association of Business Economists last week and vowed to be a tough inflation fighter. If the Fed must go beyond neutral into restrictive territory, so be it, Powell said. Meanwhile, the Chicago Fed’s National Activity Index for February showed strong improvements in production-related indicators for the month and improvement in employment-related indicators — signs all but confirming that a recession didn’t begin in February.

Employment strength. Another sign of economic vitality came in reports of initial and continuing jobless claims released late in the week. Just 187,000 people filed for unemployment, the Labor Department reported, down some 28,000 from the previous week and the lowest figure since 1969. Continuing jobless claims totaled 1.35 million, down from 1.42 million a week earlier and at their lowest level since 1970. Continuing claims have fallen more consistently than initial claims, with week-over-week improvements in seven of the past 10 weeks.

Durable goods weaker. A more cautious economic signal was the 2.2 percent decline in durable goods orders in February. Greater than expected by economists and the first decline in five months, the drop was largely the result of falling demand for passenger planes and autos, which often exhibits volatility. Core orders, which exclude transportation and military hardware, fell just 0.3 percent in February.

The week ahead

End-of-quarter positioning may make for higher market volatility through Thursday, which could hold markets back from a third consecutive week of gains. Continuing to simmer and perhaps bubble up to a boil are the Russia-Ukraine war and inflation. Here are some developments coming up this week that could turn the flame either way:

• Tuesday: A wide range of measures of economic activity are due to be reported. These include data on housing prices in January, the March measure of consumer confidence, and the number of job openings and quits in February from the Labor Department. In January, 4.3 million people quit their jobs. Is the Great Resignation continuing?
• Thursday: Everyone is likely to be watching to see if the reports on initial and continuing jobless claims continue showing the record declines that marked last week’s numbers. Figures on consumer income and spending in February will be released at the same time as the Federal Reserve’s measure of inflation, the Personal Consumption Expenditures price index (PCE) issued by the Bureau of Economic Analysis. The reading may influence the Fed’s rate-raising decisions. Finally, look for the March measure of manufacturing activity in the Chicago PMI.
• Friday: Rounding out the week will be reports on March payrolls and unemployment from the Labor Department and two reports on March manufacturing from Markit and ISM.

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