Too Hot, Too Cold, or Just About Right?

Story Highlights:

• The Federal Reserve has lowered short-term interest rates over the past several months, steepening the U.S. yield curve and reviving fears of inflation.
• But long-term interest rates remain benign, signaling inflation is not a near-term concern.
• Regardless of the data, there will always be some who think it's too hot and some who think it's too cold.

One of the frustrations in being an investor is knowing who or what to believe. Various economic indicators, ranging from employment figures to GDP numbers to interest rates are often simultaneously described as wonderful or terrible. For example, a steep yield curve is often feared as a sign of an overheated economy, while a flat curve is reviled as a sign of a cool down. Which temperature is just right?

Yield Curve Concerns, Keynesian Fixes, Broken Models: Timshel
By Mark Gilbert, Bloomberg

Interestingly, not too long ago we had a flat and sometimes inverted yield curve, and folks feared it—nearly the entire time. Investors fretted a flat yield curve would reduce the incentive for banks to lend and choke off economic growth—in fact, while we've had a flattish curve since 2005, we've seen a lending boom, healthy economic growth—and a continuing bull market. But now that the curve is turning positive, that's scary too?

There are two ends to the yield curve: a short end and a long end—for a yield curve to steepen, short-term interest rates have to be lower relative to long rates. The short end of the curve generally tends to track the Federal Reserve's overnight target for rates. But changes to short rates by themselves aren't terribly meaningful. Over the course of the current 5 year bull market the Fed has both raised and lowered short rates while the stock market—and the economy—have marched along just fine.

Long rates, on the other hand, are determined primarily by market forces as opposed to Fed policy, and can be a more meaningful indicator for the economy. Rising long rates can signal the market's increasing anticipation of rising inflation, which is one reason folks might fear a steepening yield curve. But with the 10-year US Treasury rate below 4%, much lower than the yields during the bull market run of the 1990's, it's hard to argue the market fears inflation as a legitimate near-term concern. The steepening of the curve today is due to faster falling short rates—thanks in large part to aggressive rate cutting by the Fed.

The 10-year Treasury rate isn't the only one that's falling—most corporate long-term rates have actually fallen over the past year. In fact, healthy corporations are now paying less to borrow than they were when the Fed began lowering rates last year—it's only the risky borrowers that are having trouble getting a loan.

A steep yield curve, on its own, isn't anything to fear, any more than a flat one on its own is frightening. This is a game investors frequently play—if one piece of economic news is bad, the inverse is as bad or worse. For example, if growth slows, some fear a recession and some exult in impending rate cuts from the Fed. Fed rate hikes signal inflation, which is bad, but rate cuts signal slowing growth, which is worse. Decreasing consumer spending is bad. Increasing consumer spending is worse because consumers are drowning in debt!

Focusing on any single piece of economic data won't paint an accurate picture. There isn't a single toggle that tells us the health or direction of our economy. We can survive just fine with a flat or steep yield curve. We just survived three perfectly fine years with a flat and sometimes inverted yield curve. And, the yield curve is normally positive, so we shouldn't fear that either!

Just remember a lack of consensus is inevitable, so stop waiting for some moment of glorious stasis and get on with it. After all, as the three bears can tell you, if you wait for your porridge to get just right, someone might eat your lunch.