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-term securities. The 10-year Treasury yield has stayed below the federal funds rate since May and briefly dipped below the 2-year yield in August for the first time since 2007. An inverted yield curve suggests investors are increasingly worried that a recession is approaching within the next 12 to 18 months. However, we believe synchronized global easing by central banks and fiscal stimulus will help reboot the cycle and avoid a recession. We estimate the odds of a U.S. recession in the next 12 months at less than 30%.

“In the business world, the rear view mirror is always clearer than the windshield.”
– Warren Buffett

Interpreting yield curve signals

The two term spreads most important to us are the 3-month/10-year spread and the 2-year/10-year spread:

  • Policy signal: The 3-month/10-year spread captures market expectations for central-bank policy in light of long-term expectations for economic growth and inflation. The higher (lower) the spread, the more (less) stimulative the policy stance.
  • Economic signal: The 2-year/10-year spread captures market expectations for economic growth and inflation. The higher (lower) the spread, the more (less) optimism within the market.

 

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

 

Why does the yield curve invert?

We believe a mix of cyclical and structural factors explain the inversion or flatness of global yield curves:

  • 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 concerns regarding growth.
  • Term premium: A lower term premium and the rising share of negative-yielding debt (now $16 trillion) have weighed on bond yields. Bond investors are increasingly forced to pay creditors for the privilege of lending money. This should push them further out on the curve in search of yield.
Lower term premium weighing on the long end of the curve

Lower term premium weighing on the long end of the curve

Source: Bloomberg

  • Fear of a policy mistake: Recent Federal Reserve (Fed) (mis)communications have fueled demand for safe-haven assets. Following the July rate cut, Chairman Powell’s messaging on “mid-cycle adjustments” disappointed dovish market expectations and increased fears of a policy mistake.
  • Quantitative easing: An unprecedented level of quantitative easing by central banks has weighed on long-term yields since the Great Recession.
  • Demographics: Low growth rates across developed economies, partly due to demographic trends and limited fiscal stimulus, have exacerbated the global savings glut and pushed down neutral interest rates.
  • Debt management policy: U.S. debt issuance has focused on short-term maturities (up to five years) with relatively little issuance of long-dated (10- and 30-year) debt.

 

What is the inverted yield curve telling investors?

Between an escalation of trade wars and some mixed messages from the Fed, investors have been spooked by the recession bogeyman for well over a year. The brief 2-year/10-year inversion in August, fueled by trade tensions and weak global growth indicators, sparked an equity selloff and a bond rally. Global growth has indeed cooled; Europe has disappointed as Germany’s manufacturing sector is under stress.

However, as long as the U.S.-China trade dispute does not escalate to a level whereby tariffs rise to 30% on all Chinese imports or new tariffs on autos are levied, we see the risk of a U.S. recession at less than 30% for the next 12 months. This is lower than the yield curve currently suggests. Confidence measures will have to hold up, however, to keep growth above 2% in the U.S. While business sentiment has moderated, consumer confidence remains high.

What about other recession indicators?

Because the shape of the yield curve is a reflector rather than a true driver of growth, other business cycle indicators should be considered by investors. For example, the top five economic indicators that track recession dating by the National Bureau of Economic Research 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 (firms generally act first on the intensive margin and cut back hours before turning to layoffs). Meanwhile, employment and business investment look better. Construction and temporary-help services 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. The flattening of the yield curve that followed the Fed’s July rate cut can be interpreted as a bearish signal for the economy driven by fear of a policy mistake.

Equity performance after a yield curve inversion

U.S. equities have performed well in the 12 to 24 months following a yield curve inversion, with notable outperformance during insurance-cut cycles. The S&P 500® has gained 11% on average over the 12 months following an inversion, ranging from a decline of 4% (2000–01) to a gain of 27% (1988–89). Sectors outperforming in the year following the past two 2-year/10-year inversions were financials, utilities and energy. More broadly, cyclicals and defensives have led, while value has outperformed growth in such episodes.

Equity performance during a yield curve inversion

Equity performance during a yield curve inversion

Source: Bloomberg (Aug 19th).

Conclusion

Calling for a recession is like calling for winter to arrive in the Midwest. It’s not a matter of “if” but “when.” We believe the bond market is getting ahead of itself in pricing in an imminent recession. With the Fed’s pre-emptive easing, we believe the longest U.S. economic expansion in history still has room to run, provided trade tensions do not escalate dramatically. Investor sentiment will likely continue to be driven by political risks, including the 2020 presidential election, Brexit, Hong Kong protests and the stability of the European Union. In the past year, balanced solutions have proven resilient to market gyrations resulting from political noise, with the stock/bond mix working as expected and delivering a high degree of portfolio diversification.

Related articles

No posts matching your criteria