Multi-Asset

Collapsing Yield Curve: Are recession fears valid?

Between an escalation of trade wars and Fed Chair Powell’s disappointing messaging on “mid-cycle-adjustments”, investors have been spooked by the recession bogeyman for well over a year
September 2019
  • Yields on longer-term government debt have fallen below those of short dated maturities. In Canada, the 30- year Federal bond yields fell below the Bank of Canada’s overnight policy rate of 1.75%. In the U.S., the 10-year Treasury yield has fallen below the Fed funds rate since May and briefly dipped below 2-year yields in August for the first time since 2007.
  • This unusual situation of inverted yield curves suggests that investors are increasingly worried a recession is approaching within the next 12 to 18 months.
  • We think synchronized global easing by central banks and some fiscal stimulus will help reboot the cycle and avoid a recession. We estimate the odds of a recession in the next 12 months at less than 30% in the U.S., and less than 20% in Canada.
  • Canada has the most inverted yield curve across the G10, though this is a common occurrence historically. Economic growth is solidly rebounding after a chilly winter. We believe the inversion in Canada should be addressed by the issuance of long dated government debt rather than a Bank of Canada rate cut.
“In the business world, the rear view mirror is always clearer than the windshield.”
– Warren Buffett

What are Collapsing Global Yield Curves Telling Investors?

Between an escalation of trade wars and Fed Chair Powell’s disappointing messaging on “mid-cycle-adjustments”, investors have been spooked by the recession bogeyman for well over a year. Trade tensions and weak global growth indicators caused the 2yr-10yr U.S. yield curve to momentarily invert in August (Chart 1), leading to a large equity sell-off and bond rally. While we don’t think a recession is imminent in Canada or the U.S., global growth has cooled. Europe has disappointed as Germany’s manufacturing sector is under stress.

So long as there isn’t a further escalation in the U.S.-China trade dispute whereby tariffs rise to 30% on all Chinese imports or new tariffs on autos are levied, we see the risks of a U.S. recession at less than 30% for the next 12 months. This is lower than the U.S. yield curve currently suggests. But confidence measures will have to hold up to keep growth above 2% in the U.S. Although business sentiment has moderated, consumer confidence remains elevated.

For Canada, we think the odds of a recession are slightly lower given that i) we continue to think the country is less exposed to trade disputes, ii) the housing market is responding to lower mortgage rates and iii) that Canada has fiscal capacity to safeguard the economy from a recession. We think the odds of a recession in Canada are less than 20% for the next 12 months, with the downside mainly driven by global factors.

An Impressive Track Record at Predicting Recessions: A False Positive This Time

The track record of various yield curves as predictors of recession speak loudly and deserves respect (Chart 2), especially when trade wars are causing a growing drag on global growth. However, we disagree that the economic backdrop, whether in the U.S. or Canada, warrants a panic buying of government bonds. Interestingly, when Canada experienced a technical recession in 2015 because of collapsing oil prices, the yield curve never inverted even though the shock was quite severe, especially on business investment.

Charts 1 & 2: Yield-Curve Inversions and Economic Growth

Charts 1 & 2: Yield-Curve Inversions and Economic Growth

Source: Haver.

Although Canada is a fast growing economy amongst the G10, its 3m-30yr yield curve is the most inverted in the G7 (Chart 3), whereas Italy has the steepest curve despite stagnating growth for years. This shows the extent to which yield-curve signals must be interpreted with care.

Chart 3: Canadian Yield Curve Most Inverted Across Main Advanced Economies

Chart 3: Canadian Yield Curve Most Inverted Across Main Advanced Economies

Source: Bloomberg (Aug 19th).

Interpreting Yield Curves

There are two term-spreads on the yield curve that are most important to us: the 3-month vs the 10-year, and the 2-year vs 10-year spread.

  1. Policy signal: The 3m-10yr spread best captures market expectations for what central-bank policy will do vis-à-vis long-term expectations for economic growth and inflation. The higher (lower) the spread, the more (less) stimulating the policy stance is.
  2. Economic signal: The 2yr-10yr spread best captures market expectations of economic growth and inflation. The higher (lower) the spread, the more (less) optimistic markets are.

While monetary policy is the main driver of short-term interest rates, investor sentiment usually determines the shape of the yield curve, which is typically upward sloping. The slope of the yield curve typically flattens as the business cycle matures.

 

Signals from the Yield Curve: The Sound of Sirens

Recession scares have reignited in recent weeks on the brief inversion of the U.S. 2yr-10yr segment of the yield curve on August 14th. In Canada, the 2yr-10yr inversion has deepened to multi-decade lows. What is concerning to investors is that curve-inversion is spreading across several segments of the yield curve, and the 2yr-10yr spread in particular has preceded every recession for the past 40 years. Furthermore, other parts of the yield curve have remained inverted for a lengthening period of time (such as 3m-10yr). We note that the U.S. 3m-10yr yield spread inverted briefly in March for the first time since 2007, and has stayed inverted since late May, or more than 60 days. As a result, recession probabilities have grown, with the NY Fed’s statistical model suggesting a 30% chance for the next 12 months based on the 3m-10yr spread. However, we estimate that the further collapse of the yield curve in August probably sent the model’s recession probabilities closer to 50%.

Chart 4: US Yield Curve Signaling Higher Recession Risks

Chart 4: US Yield Curve Signaling Higher Recession Risks

Source: NY Fed, Bloomberg.

Why are Yield Curves Collapsing?

We believe there is a mix of cyclical and structural factors at play to explain the inversion or flatness of global yield curves, namely:

  • Cooling of global growth: Global growth expectations have fallen, most notably in Europe and China, as the U.S.-China trade war intensified and pulled down inflation expectations. Additional tariffs on China, a contraction in German GDP, and disappointing Chinese activity data have amplified growth concerns.
  • Term premium: A lower term premium (Chart 5) and the rising share of negative-yielding debt (now $16tn) have weighed on bond yields. Bond investors are increasingly forced to pay creditors for the privilege of lending money. This should push them to go further out on the risk curve to generate yield.
Chart 5: Lower Term Premium Weighing on the Long-end

Chart 5: Lower Term Premium Weighing on the Long-end

Source: Bloomberg.

  • Fear of a policy mistake: Recent Fed (mis-)communications have fueled demand for safe-haven assets. Following the July rate cut, Powell’s messaging on “mid-cycle adjustments” disappointed dovish market expectations, raising concerns of a policy mistake.
  • Quantitative easing: An unprecedented level of quantitative easing by central banks has weighed on the long-term yields of the curve since the 2008 financial crisis.
  • Demographics: Low growth rates across developed economies partly thanks to demographic trends (rising dependency ratios, see Chart 6) and limited fiscal stimulus have exacerbated the global savings glut and pushed down neutral interest rates.
Chart 6: Dependency Ratios Rising in Advanced Economies

Chart 6: Dependency Ratios Rising in Advanced Economies

Source: World Bank.

  • Debt management policy: Both in the U.S. and Canada, debt issuance has been focused on short-term (up to 5 years) maturity with relatively little issuance done in long dated debt (10- and 30-year maturity). In Canada, the lack of supply of long-dated government debt, representing only 20% of new issuance, is probably the most important driver of the yield-curve inversion (Chart 7). We don’t think the Bank of Canada would cut interest rates in response to the severe yield-curve inversion. Instead, we believe the Department of Finance should rethink its debt issuance program as soon as possible and refocus on issuing a lot more long-dated debt.
Chart 7: Canadian Government Debt Issuance Concentrated in the Front End

Chart 7: Canadian Government Debt Issuance Concentrated in the Front End

Source: Bank of Canada.

Reading through the Inversion Leafs: Correlation is not causation

Investors panicked about the momentary 2yr-10yr inversion, but this is far from a deeply persistent inversion. For example, the longest streak has lasted 120 days for the 3mo-10yr curve and 208 days for the 2yr-10yr curve, with a total of about 4 inversions prior to a recession. Some research find that a more accurate signal is when most of the curve is inverted, while others put emphasis on money markets, or rate cuts being priced at the front end of the curve. While the evidence is mixed, the short-lived nature of the recent 2yr-10yr inversion is encouraging on the economic front. Meanwhile, fed-funds futures pricing and the persistent inversion of the 3m-10yr curve signals that Fed easing is deeply expected, not that a recession is imminent.

Because the shape of the yield curve is more a symptom rather than a true driver of growth, other business cycle indicators must be examined. For example, the top 5 economic indicators that track the National Bureau of Economic Research (NBER)’s recession dating (link) are initial jobless claims, auto sales, industrial production, the Philly Fed index, and hours worked. Of these, hours worked have recently contracted and further declines could give way to job cuts (firm’s generally first act on the intensive margin and cut back hours before turning to layoffs). Meanwhile, employment and business investment look better. Construction and temporary help service jobs remain in expansion, while core capex orders rebounded in July. Key drivers of current investment (intellectual property and information processing equipment investment) are also showing no signs of an earnings recession.

More importantly, the chief causes of recessions are asset-price bubbles, leverage, policy mistakes, and commodity price shocks. Corporate leverage is running at all-time highs, but the pace of expansion has slowed and credit markets remain calm. Second is Fed policy, which has failed to exceed dovish expectations at the last meeting in July. The flattening of the yield curve that followed the July rate cut can be interpreted as a bearish signal for the economy because of fear of a Fed policy mistake.

Asset-Performance after a Yield-Curve Inversion

Following five periods of inversion in the U.S., equities usually perform well in the subsequent 12-24 months, with a notable outperformance during insurance-cut cycles. The S&P 500 has gained on average 11% over the last 12 months, ranging from a decline of -4% (2000-01) to a gain of 27% (1988-89). Sectors outperforming in the year following the past two 2yr-10yr inversions were financials, utilities and energy. More broadly, cyclicals and defensives lead, while value has outperformed growth in such episodes.

Chart 8: Equity Performance during Curve Inversion

Chart 8: Equity Performance during Curve Inversion

Source: BMO GAM, Bloomberg.

Conclusion

Calling for a recession is like calling for winter to arrive in Canada, it’s not a matter of if but when. We believe the bond market is getting ahead of itself by pricing in an imminent recession. The longest U.S. economic expansion has to run room with the Fed’s pre-emptive easing and assuming no further escalation of trade tensions.

Political risks will undoubtedly continue to drive investor sentiment, whether it’s the 2020 U.S. presidential election, trade wars, Brexit, Hong Kong protests, or the stability of the European Union. For investors, this political noise reinforces the need to stay focused on their long-term goals with investment solutions that match their risk tolerance and investment horizon. Over the past year, balanced solutions have proven resilient to market gyrations with the stock-bond mix working as expected and delivering a high degree of portfolio diversification.

BMO Global Asset Management Disclosure:

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

This commentary has been prepared by BMO Asset Management Inc. the portfolio manager. This update represents their assessment of the markets at the time o publication. Those views are subject to change without notice as markets change over time.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

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