What the Yield Curve Is Saying

The market environment remains challenging given both rising benchmark rates and volatile spreads along the credit spectrum. It all starts with Treasuries but radiates out to MMD and relative value across the capital markets. Curve shapes are different, but themes are similar: steepness is concentrated in the front end and anticipates significant near-term Federal Reserve action with flattening on the long end. Covenant pressures remain moderate, suggesting the greatest performance drivers continue to be plan of finance development (the taxable versus tax-exempt question) and investor engagement.

SIFMA reset this week at 0.47%, which is approximately 91% of 1-Month LIBOR and represents a 2 basis point adjustment versus the March 23 reset.

What the Yield Curve Is Saying

William Galston’s April 5 Wall Street Journal piece, “How Will Inflation End,” references the perspective of British finance official Charles Goodhart on our current situation and prospects with the comment that “the single-minded focus on efficiency will be balanced by a new emphasis on resiliency in the face of disruption.” I think this observation is spot-on: since the onset of COVID, the return (efficiency) versus resiliency tension has become the defining and differentiating issue. All along the macro to micro economic chain, the test for governments, corporations, and individuals will remain fixed on how effectively they position available resources along the resiliency-to-return continuum.

The current Treasury yield curve frames the dispersion of opinions on inflation that Galston’s article references. A yield curve reflects the market’s risk-adjusted forecast of future interest rates, with the headline fixed income risk being inflation and its corrosive impact on real returns. The ideal is an upward sloping curve that reflects an economy where productivity is increasing (credit capacity is growing) but in ways that offer currency stability (modest inflation) and fair real returns. Excess inflation represents an ecosystem imbalance, and absolute rates and yield curves adjust in response until the demand for credit is dampened enough such that growth slows, supply-demand realigns, and currency purchasing power stabilizes.

Everyone now agrees that we are in the throes of non-transitory and excessive inflation, and that a return to balance will require significant tightening by the Federal Reserve. But the current Treasury yield curve seems to be communicating that we have both an actual “short-term” inflation problem and a long-term growth concern. The chart below offers a snapshot of the current Treasury yield curve versus the same period in 2021 and 2020. Three important observations:

1. Absolute rate shifts over the past two years have been significant but over the past year, the transition has been particularly sharp at the front end of the yield curve.
    
   Image

   
2. The current yield curve is exceptionally steep to year 5, reflecting the expectation that the Federal Reserve will sharply increase short-term rates (response to an inflation problem).
3. The curve is flat to modestly inverted from years 5 to 30. Classically, inverted yield curves signal an expectation of recession (anticipation of a growth problem).

The question of the moment is whether the 2022 remix of that 1970s hit “Whip Inflation Now” will represent much of a departure from the credit crisis and COVID playbook: a “crisis” triggers a dislocation which triggers a forceful and sustained intervention by the Federal Reserve; eventually the crisis moderates, and everyone thinks about transitioning to stability, which includes unravelling the impact of the Fed’s response. Since 2008 we have never achieved full stability; instead, we have bounced from a credit crisis to a pandemic-driven operating crisis to a monetary-fiscal inflation crisis and all the while the Fed has become a bigger and bigger presence. Each crisis was a unique event, but they are also all interconnected; and it seems logical that the next dislocation might well source from rebalancing the relationship between fiscal-monetary accommodation (resource expansion that carries the risk of inflation) versus tightening (resource moderation-contraction that carries the risk of recession). Perhaps this is the current yield curve’s message: we need to remove excess liquidity but doing so will be painful.

It feels like 2008 was the start of a grand experiment at the Federal Reserve to test whether Milton Friedman was right—inflation is always a monetary event—or whether our financial system has become so sophisticated that something like money supply no longer matters. We are deep into the experiment, and the scale of the whole thing has gotten quite large, which means that the resource contraction that will be required if Friedman is right will also be quite large. This would bring a very different outcome from the Fed’s sought after “soft landing” and Fed leadership is now socializing their newfound expectation that things are going to get bumpy. As recently as last Tuesday, Fed governor (and nominee to be Vice Chair) Lael Brainard shared her view that the Fed would need to tighten monetary policy aggressively through a combination of significant and rapid short-term rate increases and an accelerated wind-down of the Fed’s $9 trillion balance sheet. Healthcare balance sheets ballooned in response to Federal Reserve driven largesse in 2020 and 2021; Ms. Brainard’s comments confirm that for the foreseeable future there is no haven across healthcare operating, financing, and investing activity. The leaders who oversee these things need to embrace this new reality by developing a point of view about the appropriate resiliency-return balance at their organization and putting in place a framework to support responsive resource formation and positioning.

Trending in Healthcare Treasury and Capital Markets is a biweekly blog providing updates on changes in the capital markets and insights on the implications of industry trends for Treasury operations, authored by Kaufman Hall Managing Director Eric Jordahl.