The Yield Curve Is Not Forecasting A Recession Right Now

• What message is the yield curve giving?
• Secular reversal in short-term bond yields is being signalled
• Energy sector breaks to the upside
• Energy strength may breathe life into the CRB Composite

What message is the yield curve giving?

Despite what you may be reading, the yield curve is not forecasting a recession right now. Yield curves compare the interest rate of a long-term maturity to a short-term one. There are many possibilities, but the most popular is the 2-year/10-year spread, as shown in Chart 1. When the curve is rising it means that long-term rates are out performing their shorter-term counterpart. This is known as steepening. Steepening usually reflects an easy money policy and is associated with falling bond yields.  The curve is said to be flattening when the short-term maturity is rising at a faster pace than its longer-term counterpart.  Recently, the 2-year yield, which is sensitive to Fed policy, has been rising rapidly. Since long-term rates have been in a trading range, the curve has been flattening at a pretty rapid pace. The initial stage of flattening reflects a favorable trend of economic growth, a condition which we have recently been experiencing.

Chart 1

Staying with Chart 1, it is when the 2-year actually rises above its 10-year counterpart that we should be cautious. At that point the curve is said to invert and that gets the attention of economists. The reason, is that an inverted curve signals a tight money policy which, sooner or later, leads to a recession. In this respect, the vertical lines flag the start of the five previous official recessions. All were preceded by an inversion, but most developed after the curve reversed direction and began to steepen again. That’s important because the steepening reflects two things, an initial easing in the system and weaker economic conditions. There are two conclusions we can make. First, a recession is almost always preceded by an inversion, and that initial inversion usually precedes the start of the recession by many months. One exception developed in the 1930’s, when a recession arrived prior to an inversion. Second, an inversion is not a sufficient condition to trigger a recession, as it can take a while for the implied tight money policy to bite. Normally, a well-developed steepening process following an inversion is. The three red arrows point up such situations.

Currently, the curve is flattening rapidly but has yet to invert. Second, it is well below its 12-month MA and its long-term KST has started to roll over to the downside. This suggests further flattening lies ahead and that a recession is not imminent.

Secular reversal in short-term bond yields is being signalled

Chart 2 compares the yield curve with the 3-year yield. Since the two series move in opposite directions the 3-year series has been plotted inversely, so think of it as short-term bond prices. Between 1981 and 2011/12, prices were in a secular bull market, as each successive peak and trough was higher than its predecessor. However, between 2008 and 2016 this series experienced a trading range. That range has turned out to be an 8-year head and shoulders top, which strongly suggests that that a new secular downtrend is underway. Note also, the series of declining peaks and troughs that are now in force.

Chart 2

Energy sector breaks to the upside

Energy stocks are breaking to the upside in a broad way. For instance, Chart 3 shows that the SPDR Energy ETF, the XLE is emerging from a large base.

Chart 3

More impressive is the iShares Oil Equipment ETF, the IEZ, as its breakout is being accompanied by much heavier volume.

Chart 4

That suggests that the oil price will continue to power ahead. Back in November I wrote an article questioning whether oil might be topping since sentiment and commitment of traders data suggested some vulnerability. The conclusion was that the breakout in Chart 5 for Brent should be respected unless the red trend line at $50 was violated on the downside. That never happened, and it now looks as if the price is set to move to new recovery highs.

Chart 5

I also reviewed the price of unleaded gasoline, because it seemed as though it might have experienced a false upside breakout. That also required confirmation in the form of a daily close under $1.60. As you can see from Chart 6, it sold off to $1.65, but did not trade below the up trend line and 200-day MA. Now, the KST looks as though it may be in the process of reversing. We still need to see a close above the green horizontal line, just below $1.80. However, with oil equities breaking to the upside the odds of that happening are greatly increased.

Chart 6

Energy may breathe life into the CRB Composite

One of my favorite intermarket relationships is the ratio between the Goldman Sachs Natural Resource ETF, the IGE, and the SPDR Consumer Staples (XLP). It’s a kind of stock market way of looking at inflationary versus deflationary forces. In this respect, Chart 7 shows that there is a good correlation between this relationship, and the CRB Composite.

Chart 7

Just like the Brent price discussed earlier, it looked recently as if the ratio had also experienced a false upside breakout. Now it’s recovering again and is experiencing a positive KST. That suggests that the ratio will move higher. Given its close relationship with the CRB, there is a good chance for a breakout there as well.

Further evidence in favor of the ratio moving higher comes from an examination of its two components. Chart 8, for instance, shows that the XLP is still in an uptrend, but is very overbought and therefore vulnerable.

Chart 8

However, Chart 9 shows that the IGE has just broken decisively out of its 2017 base. It’s daily KST is also in a confirmed uptrend. In effect, IGE looks a lot stronger technically than does XLP. That does not guarantee the ratio will move higher, but it certainly looks that way!

Chart 9

Good luck and good charting,
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group of Walnut Creek or its affiliates.