The current economic expansion is now well over five years of age. To judge by the comments of Fed Governor Frederic Mishkin on Friday, one could reasonably assume that celebrating a sixth anniversary is a distinct possibility.
Yes, the expansion during the last year “appears to have been undergoing a transition to a more moderate and sustainable pace,” he advised at a conference at The Levy Economics Institute of Bard College in Annandale-on-Hudson, New York. But the jig is not yet up, he suggested. “Looking ahead,” Mishkin said, “the most likely outcome for the coming quarters is, in my judgment, a continued moderate rate of economic expansion….”
How then does one square Mishkin’s modestly upbeat forecast with the fact that the yield curve remains inverted by more than a trivial amount? As of Friday’s close, the benchmark 10-year Treasury yield was 4.67%, or nearly 60 basis points below the Fed funds rate of 5.25%.
Historically, there’s been reason to think that an inverted yield curve portended recession. In fact, some are expecting no less. But rules of thumb that worked in the past are subject to reinterpretation, if not dismissal in the complicated globalized economic paradigm of the 21st century.
In fact, if the inverted yield curve is a warning sign, there’s scant evidence that equity investors are taking heed. They may or may not be accurate, but no one can doubt their preference for optimism. Buying, in short, remains the prevailing mood in the stock market. The S&P 500 on Friday rose to a new post-2000 record. At this rate, a new all-time record is not beyond the pale, with the index now less than 5% under its former peak set in the halcyon days of early 2000.
Transition is a constant in the capital markets, but it’s never clear what constitutes prudent thinking when points of substantial transformation reign. What worked in the past is of questionable value today, but beyond that there is wide debate about how to reinterpret market signals.
At least we can agree that something’s changed when it comes to the relationship of short and long rates. As Daniel Thornton of the St. Louis Fed points out in the May issue of the bank’s Monetary Trends, the yield curve has been behaving strangely of late, as the chart from Thornton’s essay (reproduced below) shows. Clearly, the tendency of Fed funds and the 10-year yield to move in tandem has been fading in the 21st century.
Source: St. Louis Fed
But while it’s easy to document the departure from historical norm, deciding what it means, including its causes and the investment implications, is something else. “The reason for this marked change in the behavior of these rates is a topic for further research,” Thornton writes.
That won’t satisfy investors in the here and now, but interpreting revolutions in finance sometimes takes time. The caveat reminds us the Chinese historian in the late-20th century who was asked to interpret the meaning of the French Revolution. It’s too early to tell, he replied.