On the face of it, there aren’t many signs of an impending global recession. From purchasing managers’ indices to global trade, almost every economic indicator is pointing to a sustained global economic expansion.
The IMF has just revised economic growth forecasts higher, while Donald Trump has unleashed a significant fiscal stimulus. Nevertheless, the fixed income market is trying to tell us a slightly different story.
The bond market is often gloomy, preferring deflation and recession to economic growth and inflation, but the fact remains that it has a credible track record in forecasting recessions. Specifically, when the US yield curve inverts – in other words investors are paid less for lending long-term than they are for lending short-term – it is usually a precursor to a recession.
Bond Yields ‘Early Warning’ of Recession
David Roberts, head of global fixed income at Liontrust, says the shape of the US Treasury curve tends to be a good predictor of recession in the US and global economy six to nine months in advance. He adds that risk assets, notably US equities, tend to peak five or six months before a recession starts. That could suggest that the recent market volatility is more than just a wobble.
The reasons for the phenomenon are clear: interest rates rise rapidly, raising borrowing costs for individuals and companies, which in turn depresses economic growth. Long-term interest rate expectations fall. Roberts says: “Short-dated bonds rise in yield and fall in price because they tend to be very sensitive to changes in the Federal Funds rate. At the same time, investors grow concerned that tighter policy will ultimately choke off growth and inflation, so they are willing to buy long-dated bonds for capital gain and protection against economic upset.”
Since the start of last year, the US yield curve has been flattening, with some acceleration towards the end of the year. At start of the year, the gap between the two-year and the 10-year Treasury was around 140bps, but it now sits at around 50bps. In mid-January, it was even lower, but there appears to have been some pick up in economic confidence since the start of the year.
US Stimulus May Prove Ineffective
This would be worrying, but surely the US tax cuts will act to stimulate the global economy and stave off recession? In theory, yes, but – argues Daniel Morris, senior investment strategist at BNP Paribas Asset Management – there is a danger it is simply arbitraged away by the Federal Reserve. The central bank will keep hiking rates to keep the US economy close to its long-term average growth rate of just under 2%. The government acts to stimulate the economy, interest rates go up faster, thereby potentially hastening recession.
Amid all this general buoyancy, there are reasons for investors not to get carried away. While this would put the stock market a couple of months from its peak, it does suggest they should be paying reasonable attention to issues such as valuation.
That said, the trajectory may not be set in stone. Sven Balzer, head of investment strategy at Coutts says: “There can be no doubt that the US yield curve has been a good predictor of a slowdown and subsequent recession.
“However, the key moment is the inversion of the yield curve and it is not inverted yet.” In other words, while the flattening of the yield curve is a concern, it is the moment when 10-year debt is cheaper than two-year debt that really matters. And crucially we’re not there yet.
Economic Fundamentals Remain Strong
Balzer adds: “Flattening at this stage is not new and shouldn’t be a surprise. The recent budget announcement implies a far larger Treasury supply so this is keeping short-end rates higher.” He says the markets needed to reprice for a higher inflation environment, and had been slow to do so to date. This is a belated adjustment to economic reality.
Balzer also points out that other indicators are not suggesting recession. The Federal Reserve is only predicting a 10% chance of a recession within the next 12 months – this is historically low. All the other leading indicators are looking healthy, from PMIs, to economic confidence surveys, to trade volumes.
Roberts agrees that normal circumstances do not necessarily apply here. Recession is usually prompted by high borrowing costs, but even if the Fed raises interest rates a few more times, they will still remain well below the average rate for the past 40 years. Curve inversion normally follows a three-month period during which rates have moved up at least 1%, but at the moment, there have been five rate rises in two years, totalling 1.25%.
For Balzer, there would have to a meaningful slowdown in some of these indicators, not merely a loss of momentum, for him to become concerned about recession.
He says: “A change in the unemployment rate would make us nervous. We would need to see a downturn and some momentum on the downside for it to be a concern.”
If the yield curve were to continue to flatten, and threaten to invert, it may be a time for investors to reappraise their positioning. However, we are not there yet. The economic party may continue for a little longer.
