In years past, an inversion of the bond market’s yield curve would have had commentators and economists running for the hills signalling recession warnings to worried investors.
For a long time, when the yield on short-term bonds trended higher than the yield on longer-term paper a recession generally hit soon after, with some, but few, false signals created from the measure.
Two weeks ago, the three-month and 10-year Treasury bonds crossed, but this time the yield curve inversion was given scant regard by many in the market. In the three days after the curve turned negative, the Russell 1000 index of large-cap US stocks lost 2.05%.
After that, though, the index immediately resumed its upward trajectory, which had seen it gain almost 15% in the year to March 21. Since March 26, the Russell 1000 is up a further 4.1%, taking year-to-date returns to over 17%.
According to a recent survey carried out by Bank of America Merrill Lynch, 86% of global fund managers believe the inversion of the US Treasury yield curve does not signal an impending recession. Almost three-quarters expect the next recession to start in the second half of 2020 or later.
Indeed, the view from UK asset allocators and economists seem to be: the yield curve inversion should neither be ignored, nor taken as reason to panic. True, its predictive power has historically been high, but not iron-clad.
It’s also not a reliable predictor of exactly when a recession will hit. It can generally occur from anywhere between nine and 24 months after the initial event.
QE Has Distorted Bond Market
Another reason for investors not to fear a recession at this current time is because it usually takes a high proportion of yield curve to invert before the measure becomes truly predictive.
There are seven different parts of the US yield curve, explains Toby Nangle, head of global asset allocation at Columbia Threadneedle. In the months leading up to the four US recessions since 1982, the proportion of those parts of the curve that have inverted has been 85% or higher. Last month, just above 50% of those curves were inverted.
March’s signal from the bond market was more like the false dawn it threw up in 1998, says Nangle, when a similar proportion – just above half – of the curves inverted. Then, it took until early 2001 for a recession to hit; shortly before that downturn, more than 95% of the curves had inverted.
Second, and more pressingly, things have changed fundamentally in recent decades to suggest the yield curve is no longer the pre-eminent recession indicator it used to be. Many commentators now note that quantitative easing has distorted the bond market so much an inversion alone is insufficient reason to believe a recession is heading our way.
Explaining further, Talib Sheikh, head of multi-asset strategy at Jupiter, says: “The downward pressure from QE on the term premium component of the long-term bond yield has made inversions more likely for a given level of short-term rates.
“The critical question is whether short-term interest rates are above what the economy can withstand. We estimate that the current Fed funds rate is close to the so-called neutral rate and is therefore unlikely, by itself, to plunge the economy into recession.”
The term premium is the premium investors would normally demand for holding a longer maturity fixed income asset. This has fallen from an average of 100 basis points in the years prior to the financial crisis to minus 75 basis points today, Sheikh says.
Black Swans Are Harder to Predict
Another reason the yield curve may not be as good an indicator of a recession today is because the causes of most recent downturn have been led by capital markets, rather than policy-driven.
Traditionally, US recessions have been caused by sharp spikes in inflation, leading to consumers reining back on spending as prices rise. Bond markets spot a slowdown in the economy coming and, thus start to price in cuts further out, so begin to demand more for lending short term to the US Government.
But that’s no longer the case. In fact, Shamik Dhar, chief economist at BNY Mellon, thinks the 1990-91 recession was the last that came about because of inflation; Nangle reckons the last time was in the early 1980s. “Since then, the world has changed,” says Dhar.
“It was already changing before the financial crisis and I think the recessions that we’ve seen since then have been much more to do with financial instability and financial crises triggered by events in the financial markets as opposed to a rise in inflation.”
Nangle agrees, giving examples: “Before [the global financial crisis] you had dotcom boom/bust, which was a fallout of what happened in stock markets; [the failure of hedge fund] Long-Term Capital Management before that; the Asian crisis, which was kind of capital market-led; you had the savings and loan crisis in the States, which was the US banking system going all over the place.”
Bond markets do not predict these Black Swan events very well, says Dhar. “Certainly, they’re not very good at predicting what the Fed’s reaction function is likely to be in response to that kind of shock.”
In any case, a recession this time around isn’t something consumers should be too worried by, adds Mark Burgess, deputy global chief investment officer at Columbia Threadneedle. Burgess thinks we’re too wedded to the view that the next recession will be as deep as the financial crisis was.
“Clearly the 2007-2010 period was a catastrophic period in the global economy and financial markets, but it was very much led by the most enormous financial accident that then led to a real economy recession,” recalls Burgess.
“I just don’t see that happening [this time]. I can see a period where we could have two quarters of negative growth and everything would be fine. The buildings wouldn’t fall over in a way that it felt like they were going to fall over in 2007.
“But we’re all referencing ‘that’s what a recession looks like’; it doesn’t look like that. A recession is just two quarters of negative growth and that’s OK, potentially. We can withstand that.”
