Ignore The Flat Yield Curve For Now, Mark Hulbert Says

If a flattening yield curve is on your list of things to worry about, you can cross it off.

I’m referring, of course, to the difference between interest rates on bonds of short- and long maturities. A steeper curve — one in which long rates are higher than shorter ones—is considered a sign of economic strength, since it means investors are expecting the economy to be stronger in the future than it is now.

In contrast, an inverted curve — where short-term rates are higher than long rates — is a sign of impending economic weakness. And on the surface it’s easy to see why a number of the advisers I monitor are concerned. As measured by the difference in yields between the 10-year T-Note and the 3-Month T-Bill, the yield curve is heading in the wrong direction: It fell from 2.03 percentage points in January to 1.13 points in June, before rebounding slightly to its current 1.32 points.

The first reason why you shouldn’t be overly concerned about this flattening: Its primary cause was the Federal Reserve’s decisions earlier this year to raise short-term rates from artificially-low levels. The yield on the 10-year Treasury note has eased back only slightly. Compared to past cycles when the yield curve began to flatten, recent experience therefore tells us relatively little about the economy’s underlying strength.

The second reason not to be overly concerned: Even if we take the recent flattening of the yield curve at face value, it still translates into a very low probability of a recession in the next 12 months.

Consider one famous econometric model based on the slope of the yield curve that was introduced two decades ago by Arturo Estrella, currently an economics professor at Rensselaer Polytechnic and, from 1996 through 2008, senior vice-president of the New York Federal Reserve Bank’s Research and Statistics Group, and Frederic Mishkin, a Columbia University professor who was a member of the Federal Reserve’s Board of Governors from 2006 to 2008. According to that model, there currently is less than a 10% probability that a recession will take place in the next 12 months.

To be sure, that model in January said that this probability stood at less than 5%. So the gloom-and-doomers are correct — even if disingenuous — when they declare that the probability of a recession has doubled over the last six months. But it’s important to put that doubling in context, since the probability in January was so low that almost any increase will look significant proportionally.

None of this should be taken to mean that there isn’t plenty for investors to worry about. But when advisers start worrying about things that objectively are quite benign, they in effect are helping to build a Wall of Worry that bull markets like to climb.

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