Market outlook: Yield curve suggests volatility for U.S. economy

The dominant economic stories of the past few weeks pertain to the rising rate of inflation, the Fed's efforts to control inflation, the war in Ukraine, the price of commodities (especially oil) and the yield curve. These stories are big, long, complicated and extremely important. They affect every American household and business, especially the businesses that comprise the plastics industry.

It will take a long time before anybody garners a deep understanding of these stories, but for this column I will to attempt to shed a little more light on the discussion of the yield curve.

On the chart I have graphed two yield curves: one from April 1, 2022, and one from exactly one year earlier, April 1, 2021. A yield curve is a snapshot on a given day showing the percentage yields, or interest rates, the purchaser of the underlying Treasury bond or note will be paid at maturity. The yield curve changes a little bit every day. When compared with last year, the yield curve has changed shape and shifted upward. This data is posted daily at treasury.gov.

The U.S. government is a huge borrower, and it borrows funds (sell Treasurys) with a wide range of maturities. There is a highly liquid secondary market for these instruments, and that is why the yield curve constantly changes. You can buy any of these instruments any day the market is open and then sell it anytime thereafter.

The thing to keep in mind is that their respective prices fluctuate constantly depending on what the market collectively believes about the outlook for the economic conditions in the U.S. The actual yield a holder at maturity receives will depend on how much they paid for the bond or note at the time they purchased it. These two curves indicate the yields one would be paid if they made a purchase on April 1 of either this year or last year.

For the sake of simplicity, I will state that interest rates (and yield curves) are primarily affected by two closely related things: the market forces of supply and demand for these Treasurys; and the Fed Funds Rate, which is the short-term rate the Fed charges banks to borrow money. Once the market gets close to equilibrium with these levels, then interest rates for things such as mortgages, auto loans, savings accounts and credit cards are set.

There is a long-established tradition of trying to forecast future economic trends based on the shape and the slope of the yield curve. I believe near-term historical yield curves are useful for understanding present economic conditions. They can even flash warning signs about the changing probabilities of future outcomes. But they should not be relied upon too heavily. They should be monitored, but they are only a part of a comprehensive forecasting model.

So what can we glean from this chart? I will start by saying that neither curve is indicative of a healthy economy that is expected to exhibit solid, stable and sustainable growth in the long term.

The curve from last year is way too low. The slope of the curve for the longer dated maturities (the right half of the curve) is about right, but the short end is too shallow. Last year, the Fed was trying to stimulate economic activity by keeping interest rates low. If you adjust for inflation, all of the yields last year were negative. Economists describe this situation as "accommodative." The argument for creating such a condition is that it is necessary in order for the economy to recover quickly from a recession.

The bad news is that it raises the risk of rewarding profligate borrowing, spending and speculating while at the same time penalizing saving. The results can be rapidly rising inflation, market bubbles and a spike in bankruptcies and bad debt. Some of this risk is already being realized.

Last month, the Fed started a well-telegraphed program to slow the rate of inflation by raising interest rates. This had an obvious effect on the shape of the yield curve. But in my opinion it still did not result in a "healthy" curve.

The short end of the curve now has a pretty good slope, but the long end is flat. The interest rate for the two-year note and the 30-year bond is exactly the same. There is a small inversion in which the yield from a two-year note is just a little higher than the yield from a 10-year note. And the entire curve is still well below the prevailing rate of inflation, which means it is still below where it should be in a stable and vibrant economy.

When the cost of borrowing money for two years is the same as borrowing it for 30 years, and more than borrowing it for 10 years, what you have is market uncertainty, hesitancy and doubt.

Markets have acknowledged the Fed's desire to fight inflation with an increasingly aggressive program of raising near-term rates, but it is unclear how this program will work out in the longer term. This attempt to slow the economy down might just push it into an outright recession. And if the U.S. economy is headed for a recession, then one of the best places to park your money and ride out the downturn is in safe and liquid, long-term U.S. Treasurys where you are at least getting a modest rate of return while at the same time not risking the loss of too much of your capital. There is not a strong consensus that this is where we are headed, but money is getting allocated in that direction just in case.

I strongly believe the Fed Funds Rate should be at the neutral level — the rate that neither encourages or discourages sound borrowing activity. My research indicates that this is the condition that creates optimal growth in demand for plastics products and the majority of plastics end markets in the long run. This rate is just above the long-term rate of stable inflation or about 2.4 percent. The short end of the yield curve should start right about there and then move upward as the maturities get longer. The yield for the 10-year note should be about the same as the long-term rate of growth in the overall U.S. economy. The yield for 20-year and 30-year maturities should be incrementally higher.

Clearly, we have a long way to go before we get to a curve like that, and we will probably have to endure some bumps along the way. For my money, I am not yet convinced that a recession in the economy is eminent despite the recent two-year/10-year yield inversion. I do believe we are heading into the late stages of an economic cycle and overall growth rates will decline. I am not ruling out a recession at the end of this cycle, but right now the labor market is strong, and this trend might be enough to keep economic growth positive. The price of oil is a wild card, but there is still a substantial amount of both uptrend and downtrend risk in the crude oil market.

The one thing I will predict is continued volatility.