The yield curve has inverted, so will recession follow?
History was made in the US bond markets in the middle of this month. On 14 August, the yield on ten-year US government bonds fell below that of equivalent two-year paper for the first time in 4,453 days. Although inverted yield curves had already been a topic of discussion in the capital markets for several months prior to this, it had been other maturity pairings, such as two-year and five-year bonds, that had inverted. But the relationship that is most closely watched by the markets is the one between two and ten years. This is because the US economy has fallen into recession following each occasion that this yield curve has inverted since 1956. Sceptics argue that an inverted yield curve is actually more symptomatic of uncertainty surrounding the prospect of lower growth than the portent of a recession. Either way, it is definitely a warning sign and has been interpreted as such in the markets.
Inverted US yield curve signals possible US recession
Strong market reaction
The equity markets immediately came under pressure after the yield curve inverted. At the head of the downturn were banks, whose earnings prospects deteriorated as the option of maturity transformation was closed to them. In the bond markets, there was demand for safe havens, which pushed yields on ten-year US Treasuries even further below their already low level. It was notable that the yield curve flattened from the long end this time, a phenomenon known as bull flattening. In the past, it had often been the case that the US central bank (Fed) had used its cycle of interest-rate rises to invert the yield curve from the short end (bear flattening). This alone shows that the situation in 2019 is quite different and is not easily comparable with the previous nine times that the yield curve has inverted since the 1950s.
High demand for US government bonds
There are good reasons why US Treasuries are in high demand at the moment. Firstly, from the US perspective, it is a concern that the latest escalation in the trade dispute with China is now threatening to impact on US consumers too, as some of the goods they buy are now being dragged in to the crossfire. Furthermore, inflation expectations among economic agents remain at a low level – and that’s despite the Fed having clearly shown its willingness to lower interest rates. US yields have fallen so quickly of late that even the real rates of return have turned negative again.
Finally, the US central bank is likely to have disappointed a lot of market players. At the end of July, the Fed lowered the interest-rate corridor by ‘only’ 25 basis points. In previous recessions preceded by an inverse yield curve, interest rates were around twice as high and so the central bank had much more scope for easing its monetary policy. The Federal Open Market Committee led by Fed Chair Jerome Powell should actually now be even more inclined to ‘get ahead of the curve’. But in his speech at the end of July, Powell instead stressed how firm certain key US economic data had been and that major expansionary measures would not be necessary at this point in time. It’s possible that the Fed is looking to assert its independence in the face of the political discourse in Washington. So much so that when push comes to shove, it may even risk putting itself in a difficult situation to achieve this. In recent months, US President Donald Trump has taken every opportunity to launch broadsides against his central bankers and has regularly urged them to cut interest rates.
Investment pressure drives foreign investors to US Treasuries
But it’s not just internal pressures that have been driving down US yields of late. In Germany, Denmark and the Netherlands, for example, yields on even 30-year bonds have been pushed into negative terrain, so international investors in search of returns have recently emerged as prominent buyers of US paper.
In the eurozone, it is mainly fears of an impending recession that have been pushing yields on German government bonds down to record levels. There has also been further gloomy economic news from China. Faced with such bleak prospects, many investors in search of duration and yield are evidently homing in on US government bonds. Despite US yields falling ever lower, the spread over German government bonds (transatlantic spread) remains more or less the same at around 2 per cent.
US domestic economy still robust
So does all this mean that a recession looms for the world’s largest economy? Not necessarily. On average, it has taken 17 months from when the US yield curve first inverts for the US economy to actually fall into recession. What’s more, Union Investment’s experts believe that the prevailing concerns about the state of the US economy are somewhat overblown. The US labour market, a key pillar of the dominant domestic economy, continues to be in very good shape. The problems will start when the situation here begins to deteriorate. Pressure would also have to build on corporate bonds, but this has not yet been evident on a broad basis. The high-yield segment is showing initial signs of weakness, but investment-grade paper remains unaffected. Tighter credit conditions would undoubtedly be a warning, but there is no sign of these on the horizon either.
A lot of importance is being attached to consumer spending right now. After all, the US consumer is the mainstay of the US economy. The latest retail sales figures were up by 0.9 per cent, which was higher than the anticipated increase of 0.5 per cent and is not indicative of a period of weakness ahead.
Summary: warning sign, yes – recession, no
An inverted US yield curve is first and foremost a warning sign and should not be ignored. But it does not necessarily mean that a recession will follow. The situation now is different to the previous nine instances that have occurred since 1956, not least because this time the US yield curve is flattening from the long end. For now, the hard economic data is pointing towards a downturn, but not a recession.
Unless otherwise noted, all Information and illustrations are as at 19 August 2019.