Don't fear the yield curve

In a recent CNBC interview, U.S. Treasury Secretary Steven Mnuchin said he is "not at all concerned" about the narrowing gap between long- and short-term Treasury yields. Perhaps that doesn't seem shocking. But the financial services industry is chock full of claims that recent narrowing between 10-year and 2-year yields signals trouble ahead.

Fisher Investments' research argues Mnuchin is right -- worries about the yield spread seem premature. Many hinge their views on the wrong measure.

Many economists see the yield spread-the gap between long- and short-term Treasury yields-as a reliable predictor of economic conditions ahead. Banks borrow short term (think deposits or interbank lending) to lend long term (business, auto, home loans). So when long-term rates exceed short, bank lending is profitable-and, likely, plentiful as a result. When short-term rates top long, the yield curve is inverted. This typically signals troubled credit markets. Inverted yield curves have preceded every post-war US recession.

Recently, with the Federal Reserve hiking the fed-funds target rate while the 10-year Treasury yield stays range-bound, spreads are shrinking. Especially the 10-year minus 2-year yield. This yield spread is at its narrowest in a decade.

Flat isn't inverted, meaning it isn't signaling trouble today. But at around 0.2%, this is narrow and many suspect it wouldn't take much to flip it. But this measure, in Fisher Investments' view, is the wrong gauge to use. It's a view reinforced by a recent analysis from the Federal Reserve Bank of San Francisco.

The reason why this is the wrong measure ties back to banks' operations. The 10-year yield is a good proxy for long-term interest rates. But the 2-year yield doesn't match bank funding well. Fisher Investments' research shows few banks fund lending with maturities this long. It is more realistic, in our view, to use rates much closer to overnight rates like the effective fed-funds rate or the 3-month Treasury yield.

A look at spreads calculated using these shows a wider yield spread-not worrisome.

The 10-year minus 3-month spread is presently at 0.75 percentage point. The 10-year minus effective fed funds is 0.96. It would take a large move in either short rates, long rates or a combination to invert the curve anytime soon. Further, even if the yield curve inverts, it can rebound as it did in 1998.

And, while inversion is an indication of troubled credit markets, it isn't a timing tool. Stocks can rise-and the economy grow-for many months while the curve is inverted. Finally, in a global economy with interconnected banks, the global yield curve matters most. It is similar to the U.S. 10-year minus fed-funds spread presently-and hasn't materially narrowed all year.

None of this signals looming trouble, in our view.

By: Aaron Anderson, Senior Vice President and Head of Research at Fisher Investments.

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