Deep Dive: Do low yields, rising inflation foretell economic slowdown?

For nearly 70 years, short-term interest rates and longer-dated Treasury yields have risen ahead of, or at least roughly together with, each upsurge in inflation. But not this time. Is their current failure to move in loose formation a warning of impending trouble for the economy?

Financial theories generally suggest that when inflation rises, interest rates rise to counteract it, so there is an initial direct correlation between the two, followed by a period of inverse correlation as the higher rates slow the economy and quell inflation.

But that is theory. In the real world, since the spring, inflation has ballooned yet both short and long yields have held relatively steady or within a narrow band at historically low levels. Meanwhile, buyout multiples have eclipsed pre-pandemic highs to reach a new record, and high yield's option-adjusted spread has hovered near all-time lows.

Explaining it

The Federal Reserve has, of course, been holding the Fed Funds rate near zero. Fed Chairman Jerome Powell had until very recently argued that inflation was "transitory," caused predominantly by unprecedented stimulus funds and supply chain bottlenecks, and anticipated that in short order, inflation would revert to around 2%.

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He has now changed his tune, telling a U.S. Senate hearing on Nov. 30 that it is "probably a good time to retire" the word "transitory" and that factors driving inflation higher "will linger well into next year." But the Fed is not yet ready to lift the Fed Funds rate and, perhaps surprisingly, the U.S. 10-year note yield, a proxy for long yields, actually declined on the day Powell spoke about this.

A low Fed Funds rate cannot take sole credit for keeping the U.S. 10-year Treasury's yield range-bound at around 1.2%-1.75% over the last 10 months. Quantitative easing might partially explain it, although the markets have known for a while that Fed tapering was about to begin. The multitrillion-dollar stimulus cash injections might also be a reason for low yields, but we are past the peak of that cash flood.

It is possible that yields are being held down by money flowing into fixed income products from retirees de-risking as they sell stock market holdings, as suggested by Ben Carlson in a Fortune Magazine story. And the U.S. 10-year Treasury yield is higher than the yield on many other nations' 10-year sovereigns, making the U.S. paper appealing to foreign buyers, according to Dimitri Delis of Piper Sandler Cos. and Richard McGuire of Rabobank, as they noted in a Marketwatch interview.

What does history say? Applying lessons from the past to predict the future behavior of U.S. Treasury yields and the economy may be the portfolio manager equivalent of generals fighting the last war. Still, it is worth going back to see what happened since Dwight Eisenhower's presidency to get a sense of what might happen next.

The first 30 years

With the U.S. Treasury 10-year note standing in for long yields and the Fed Funds rate for short rates, the following chart shows that from 1953 through 1982, inflation and yields on both debt instruments rose steadily in a series of climbs interrupted by recessions. Over that remarkable period, 10-year yields climbed more than fivefold to a 1981 peak above 15%, the Fed Funds rate rose to over 19%, and inflation lifted from under 1% to a 1980 peak above 13%. Note that the source for inflation data within this story from 1953-1982 is the annual Consumer Price Index for All Urban Consumers published by the Federal Reserve Bank of Minneapolis, and from 1983 on is the monthly Median Consumer Price Index calculated by the Federal Reserve Bank of Cleveland and the Ohio State University, published by the Federal Reserve Bank of St. Louis.

An old Wall Street adage holds that markets move six months to a year in advance of an event the move may be predicting. In this 30-year period, the rise in 10-year government yields and Fed Funds faithfully followed the adage: each inflation lift-off in those years was preceded, sometimes by more than one year, by rising interest rates.

The U.S. economy was buffeted by four recessions from 1957 through the 1970s and then by one more between January 1980 and December 1982; the last period technically contained two recessions, but they are commonly thought of as a single "double-dip" recession. Each was led by rising interest rates and inflation and, as would be expected, each recession saw their decline.

Significantly, each of the five recessions was also preceded by inverted yield curves, where the yield on short-term Treasury Bills exceeded, for at least a brief time, the 10-year Treasury yield. That makes sense as the inversion is warning of weaker business activity in the future.

From 1983-2021

Following the double-dip recession, inflation quickly fell below 5%. But while inflation may have been tamed, it was not completely dormant. Prior to the 2021 inflation spike, the consumer price index rose four times — albeit while staying within its low-single-digit range.

As in the 1950s-1970s, the four inflation upticks came in advance of the period's four recessions — in 1990, 2001, 2008, which officially began in December 2007, and 2020. Also as before, the Fed Funds rate and 10-year Treasury yields rose with inflation, and each of the recessions was presciently telegraphed by inverted yield curves.

It is worth digressing for a moment to recall the lead-in to the 2020 recession. Beginning around 2016, the Fed Funds rate, the 10-year Treasury and consumer price index all began rising. Then in 2019, the yield curve inverted, while short rates and long yields started declining. That is precisely the same pattern as in every pre-recessionary period since the 1950s. It is easy to forget now, but these data points were not reacting to the pandemic. Rather, a U.S. economic slowdown had become part of the conversation. Then the pandemic hit full-force and the economy nosedived.

Now inflation is running hotter than in decades, yet short rates are near zero and the U.S. 10-year note has fallen to around 1.4%.

Multiple conundrum

Another conundrum facing investors is the current high level of buyout multiples. Multiples have doubled from a low of 6x during the 2001 recession to 12x, and some sources say over 13x, today, while the 10-year note yield fell from around 5% to 1.4%.

Ten-year Treasury yields bottomed in the pandemic-clouded summer of 2020 and have roughly tripled since then. The last time the 10-year Treasury was around current yields, in early 2016, buyout multiples averaged around 10x, at least 20% under today's level. Were prices cheap in 2016? Or are they expensive today?

The disconnect in multiples may be the result of the record amounts of money pouring into private equity. Or perhaps these multiples are predicting corporations being able to pass through inflation-driven higher costs and growing earnings.

Recession looming?

One conclusion to be gleaned from history is that if the Fed eventually lifts the Fed Funds rate but long yields continue holding here — regardless of why they stand pat — the yield curve will flatten and perhaps even invert, triggering a recession warning that has worked every time since the 1950s.

Maybe that is exactly what yields are warning about. Delis and McGuire raised the specter of weak economic growth and disinflation ahead. And Beth Ann Bovino, S&P Global Ratings' U.S. chief economist, recently reduced her 2021 forecast for U.S. GDP growth to 5.5% and cut her 2022 GDP growth projection to 3.9%, from 5.7% and 4.1%, respectively. While the new figures still represent a robust economy, maybe the reluctance of long yields to rise is heralding a less-than-rosy future and more downward revisions ahead.

Then there is the new uncertainty generated by COVID-19's omicron variant. It was obviously not on investors' radars during the past months, but back to that adage about the market moving in advance of events, perhaps the 10-year Treasury's level has been warning of a dire scenario that investors were failing to consider.

Investors generally expect that following the Fed's tapering, it will raise its Fed Funds target, elevating the cost of debt and making floating-rate capital structures more expensive, which might put pressure on multiples — unless, as mentioned, inflation-driven price increases boost earnings faster than debt costs grow. Lower multiples, and so lower valuations, could trigger an equity market repricing, resulting in investors feeling poorer, leading them — as consumers — perhaps to spend less and again raising the specter of recession.

Or maybe the supply chain issues will soon abate, inflation will shortly ease, Fed Funds target increases will be minor, and investors can continue operating in a low-inflation, low interest rate, high-buyout-multiple environment, waiting for a shoe that — until now — has refused to drop.