Global stock markets have been in retreat since Friday on fears a US recession is not far away after part of the US yield curve inverted for the first time since 2007 last week.
With the current US economic expansion on course to reach the longest on record later in the year, we’ve seen sporadic recession predictions from economists and other commentators.
The market correction seen in the fourth quarter of 2018 renewed those claims, though risk assets’ flying start to 2019 looked to give weight to economist Paul Samuelson’s 1966 quip that “stock markets have predicted nine of the last five recessions”.
While stock markets – and, indeed, economists – may be poor forecasters of recession, there is one proven predictor: the yield curve. The yield curve inverts when shorter-dated US Government bonds yield more than longer-dated bonds.
Normally, the yield curve will be upward sloping as bond investors expect to be compensated more for tying their cash up for longer periods and are subject to greater inflation or interest rate risk. This relationship occasionally breaks as near-term fears mount and bond investors start to demand more compensation for shorter-term loans than longer ones.
When short-term rates are meaningfully higher than long-term rates for an extended period it becomes unprofitable for banks to lend, explains Michel Perera, chief investment officer at Canaccord Genuity Wealth Management. This spells trouble for the economy, as bank lending starts to dry up in response, eventually leading to a credit crunch.
The yield curve has inverted ahead of every one of the past nine US recessions and has thrown in only one false signal in the past half a century, so it’s certainly an indicator to take note of.
Late in 2018, the yields on the five-year Treasury note briefly fell below that of the two-year and three-year securities. This event was generally brushed off by market commentators, as it’s not the key measure.
Most prefer to look at the 10-year yield versus either the three-month or two-year yield. When the two-year versus 10-year spread inverts, a recession usually hits between six and 18 months down the line.
Should Investors be Worried?
There seems a difference in opinion between commentators over whether the latest inversion is cause for concern.
One ought to heed the recession warning the yield curve is sending us simply because it has proven reliable so often in the past, James Dowey, chief economist and chief investment officer at Neptune Investment Management tells Morningstar.co.uk.
However, for reasons he’s noted in the recent past, “it is not yet time to panic”. The term premium component of the curve, which is the return investors demand for holding a 10-year Government bond over a two-year Government bond, has been supressed by quantitative easing over the past decade.
This means it is now “quite easy for even modestly pessimistic growth expectations to invert the curve”, Dowey explains.
Most commentators are watching to see if the inversion becomes prolonged. The three-month/10-year curve tends to precede recessions when it inverts for greater than 10 straight days, notes Rory McPherson, head of investment strategy at Psigma Investment Management.
If it is only a brief inversion, says Maurice Harari, manager of the OYSTER Multi-Asset Diversified fund, it could be one of those few false signals. “In the past, there have been some periods when the yield curve briefly inverted without a recession following, like in the late 1990s,” he adds.
Others put more weight on the two-year versus 10-year spread as being the eminent recession indicator. As at close of play on Monday March 25, that spread stood at 17 basis points.
Some, meanwhile, just see the inversion as an overdue reminder that economies are slowing and that a recession isn’t on the cards for 2019. Recession risk is higher for 2020, admits Esty Dwek, senior investment strategist at Natixis Investment Managers, but for one to hit during an election year is unlikely with the Fed’s market-friendliness likely to help extend the cycle.
Perera agrees, pointing out that none of the normal signals of a US recession are yet flashing red. These signs include falls in profit margins, financial stress, corporate leverage and a housing market collapse.
Finally, Harari adds that in this unprecedented environment of prolonged, ultra-accommodative monetary policies, it is natural to see yield curves flatten. As a result, he thinks it could be hazardous to attempt historical comparisons.
Is This Time Really Different?
But these claims could be akin to this-time-is-different syndrome, a concept floated by economics professors Carmen M. Reinhart and Kenneth S. Rogoff after the Great Financial Crisis.
“This unrealistic optimism afflicted bankers, investors and policymakers before the 1930s Great Depression, the 1980s Third World debt crisis, the 1990s Asian and Latin American meltdowns and the major 2008-09 global downturn,” the Harvard University lecturers wrote 10 years ago.
They add that in each of these cases, key decision makers adopted beliefs that defied economic history. These included claims in the 1920s that large-scale wars were a thing of the past after the Great War; and speculation in the 1980s that high commodity prices, low interest rates and reinvested oil profits would prop the economy up forever.
The most recent folly were claims in 2008 that globalisation, better technology and sophisticated monetary policy would prevent an economic collapse. “Every time, fiscal leaders thought they had learned history’s lessons and that this time the economy was different,” Reinhart and Rogoff said; every time, they were proved wrong.
Jason Borbora-Sheen, co-manager of the Investec Diversified Income fund, is certainly taking the threat seriously. In fact, he says his team has put the probability of a US recession in 2020 at 50% ever since around the start of the year.
“If you look at different ways of cutting up the yield curve, all of them send a very similar message, which is that recession probabilities have certainly increased,” he explains.
One other measure that is pointing to a recession are the Fed Funds futures contracts that trade in expectations for US interest rates. Expectations for very near-term rates have been inverted for a while now and turned very deeply negative on Friday, says Borbora-Sheen.
“So, you’ve got quite a lot of evidence coming from the bond market that there’s a recession risk and we would ascribe to that,” he adds.
Of course, it's worth noting that while the yield curve is a good predictor of there being a recession ahead, it's fairly poor at pinpointing exactly when one will occur, notes Vicky Redwood, senior economic adviser at Capital Economics.
That's shown by the general lead time being anywhere from nine months to two years away. "So even if a recession is coming, it might still be a long way off," Redwood says.
It certainly pays to listen to, and keep an eye on, the yield curve – just don’t get too carried away just yet.
