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What the yield curve is really telling us

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      By Eric Stein, CFA, Co-Director of Global Income, Eaton Vance Management

      Note: This is the latest blog post in a series to help advisors and investors navigate the recent volatility and understand what the yield curve is saying about the U.S. economy.

      Boston - Investors are hyper-focused on a small technical inversion at the front end of the Treasury curve. Earlier this week, the yield on 5-year Treasurys dropped below that of 2-year Treasurys for the first time since 2007.

      The takeaway is that inverted yield curves have a good track record of predicting recessions in the past. However, I believe investors are missing the more important phenomenon, which is the flattening of the curve over the past few years.

      While a flattening of the curve is to be expected in a Federal Reserve tightening cycle, I have a slightly different view on whether or not a truly inverted curve (which compares 10-year and 2-year Treasurys -- not the small technical one we have now) is a major waring sign for investors.

      To be clear, I do think an inverted curve is not a good signal for the economy. While I acknowledge that there are many technical factors that weigh on the yield curve, as opposed to just the markets' view of the growth and inflation prospects of the U.S., I do think the yield curve is important to look at.

      The shape of the yield curve has been dismissed by many market participants, as well as many Fed officials. Yet to me, it shows that the market isn't that confident in the future growth of the U.S. economy (despite growth being very good today). Also, the shape of the curve may signal that the Fed is making a policy mistake.

      If the market was truly confident that the U.S. economy had achieved escape velocity from 2% growth for most of the post-crisis period to a sustainable level of 3% (which is close to what we have achieved this year), then longer-term U.S. Treasury yields should be higher than what they are today.

      Bottom line: While I was happy to see some of the curve steepening that was occurring a month or two ago, the strong flattening this week, especially given the positive outcome of the Trump-Xi meeting at the G-20 meeting and a Fed that has made more dovish communication recently, is somewhat concerning to me. I would never place all my forecasting eggs in one basket, but certainly count me in the camp that thinks the yield curve conveys valuable information. I think investors and policymakers who dismiss this market-based signal do so at their peril.