Bond markets tend to reflect a gloomier outlook than more Tigger-like equity markets and, for the past few months, that gloom has appeared even more entrenched. In particular, the inversion of the US yield curve - typically a precursor to recession - has given investors pause for thought.
The yield curve inverts when short-dated bonds have a higher yield than long-dated bonds - three-month US Treasuries now yield 2.08%, against 2.05% for 10-year bonds. This is unusual because investors would usually demand a higher yield to tie up their money for longer. It shows that markets believe interest rates will have to come down in future - usually in response to a weakening environment. As such, it is seen as a harbinger of recession.
The first problem with using yield curve inversion as a predictive tool is that it doesn’t predict when recession will arrive. Ed Smith, head of asset allocation research at Rathbones, says: “Since the mid-1950s, the yield curve has inverted on average 14 months before a recession. But behind that average is a lot of variation – last time there was 24 months between inversion and recession. The peak in the equity market tends to come just three to six months before a recession, however.”
A lot can happen in the months between inversion and recession. Smith points out that selling equities as soon as the curve inverts could cause investors to miss out on rising equity markets for some time: “Missing out on the final few months of returns is often prudent, but missing out on the final few years may be less forgivable.”
A Reliable Indicator?
Some investors dispute whether yield curve inversion is a reliable indicator of recession at all. John Greenwood, chief economist at Invesco, describes it as a "reduced form analysis" - or shorthand. In his view, an inverted yield curve will normally only be followed by a recession when it is a symptom of tightening monetary conditions. That is not the case today.
Greenwood explains: “If the central bank tightens, it reduces the amount of money in the market and explicitly raises the short-term rate. We haven’t had that this time - the Federal Reserve has not raised rates and there has been no contraction in the amount of money available. If anything, bank lending growth has got faster and the next interest rate move is likely to be down.”
Bond markets reflect supply and demand, Greenwood says: “Investors will hold long or short-term bonds for a variety of reasons. There will be supply changes – such as a rising fiscal deficit - and demand changes such as a view that inflation was going to fall - influencing the price of government bonds.” Today, there is high demand for long-dated bonds given lower yields on short-dated bonds, which has created demand and helped push yields lower.
Richard Hodges, manager of the Nomura Global Dynamic Bond Fund, says it is more informative to look at the two-year yield curve. Here, the curve is steepening. This suggests the one-year yields are the anomaly: “Everything else looks normal. If anything, the curve on the two-year US treasury has been steepening, with longer-dated bonds giving higher yields. The whole of the yield curve has been distorted by central bank activity.”
He says that the US is certainly slowing: “It would be naive to think otherwise, given that economic activity in China is slowing and Germany is in an industrial and manufacturing recession.” However, the yield curve inversion is not helpful at this point in determining when and how this will happen.
Look at the Indicators
Greenwood points out that most of the US economic indicators are still relatively buoyant in spite of the global slowdown - inflation is low, consumer and financial sector balance sheets are strong and there are few constraints on spending. There is little sign of the type of conditions that would warrant a rapid tightening in money supply, though he remains alert for higher inflation and borrowing.
Smith says Rathbones’ indicators suggest a less than 10% chance of the US economy being in recession within the next year. However, there remain some major downside risks (trade war, Iranian crisis) that are not captured by purely quantitative approaches.
Jeff Keen, a director and co-head of fixed income at Waverton Investment Management says: “In financial markets there are very few hard and fast rules. Almost as soon as they are ‘discovered’ they tend to fail. This has been one of the rare instances of a signal that has proved to be reliable (so far)...policy measures must have had a distorting effect on the shape of the yield curve so past signals and relationships should perhaps not be viewed with the same degree of confidence in this cycle...As yet, we have not seen enough evidence that this slowdown will develop into a more serious slowdown.”
