AuthorLukasz de Pourbaix
TitleChief Investment Officer, Lonsec Investment Solutions
DateApril 29, 2019
The Fed may have put its tightening plans on ice, but the yield curve is signalling that all may not be well in financial markets.
This article is intended for licensed financial advisers only and is not intended for use by retail investors.
The Fed may have put its tightening plans on ice, but the yield curve is signalling that all may not be well in financial markets. Yields on US government bonds have been moving lower since December 2018, when the Fed responded to market concerns by moving to a ‘neutral’ stance, thereby delaying further tightening. But the rate at which longer-term yields have fallen in response has ended up fulfilling the market’s fear of a yield curve inversion, which is traditionally a predictor of an economic recession—and a fall in equity markets.
Fears of a flattening or inverting yield curve cropped up about a year ago in March 2018, but back then yields were on the way up, with expectations of future Fed tightening and a gradual rise in inflation prompting investors to reassess long-term interest rates. While the 10-year yield moved higher, shorter-term rates also rose in line with the Fed’s tightening path, producing a very flat looking yield curve. The situation now is a bit different—the yield curve did indeed invert in April this year, at least across the 3-month to 10-year portion of the curve, but remains upward sloping beyond that range. Compare this to the shape of the yield curve during the previous tightening phase (way back in 2004) and things certainly look different this time around.
Source: US Treasury, Lonsec
If you went to university before the global financial crisis, you would have been taught that a yield curve with a positive slope is a sign of a healthy economy and healthy markets, and traditionally this has certainly been the case—a steepening yield curve generally means investors expect rising inflation and stronger economic growth. In contrast a flat or inverted yield curve means short-term inflation expectations have accelerated relative to longer-term expectations, pointing to low growth and a heightened risk of recession.
Today, things are not quite so straightforward. With the advent of quantitative easing and record low interest rates, as well as structural transformations taking place within economies, the power of the yield curve as a predictor of doom has been brought into question. In fact, some argue there is a risk in overreacting to what could possibly be a false signal. In the world of statistics there are two broad errors humans can make, known as Type I and Type II errors. We risk making a Type I error if we believe the recession signal to be true when it is in fact false. On the other hand, if we assume everything is fine and that the yield curve can be safely ignored, we risk committing a Type II error if the signal is in fact valid. Unfortunately, the elimination of both types of error is impossible.
Source: Bloomberg, Lonsec
The yield curve has been an area of recent focus at the Fed and the academic community, but even among some of the world’s leading economists there is no consensus. The San Francisco Fed contends that an inverted curve continues to be a predictor of recessions (especially the 3-month to 10-year curve), while former Fed chair Janet Yellen among others believes that, given abnormally low cash rates, this time it’s different. Inverted yield curves have occurred on only eight occasions since 1958. The US economy has slipped into a recession within two years of an inverted yield curve more than two-thirds of the time. While this is a well-known phenomenon, investors have always debated whether an inverted yield curve is truly reflective of fundamentals or whether it is nothing more than a spurious correlation (although possibly one with the power to create a self-fulfilling prophesy).
April’s inversion contributed to a rally in bonds, although this proved short-lived as the curve quickly moved back into positive territory. Markets subsequently priced in a full Fed cut by the end of 2019 and a second cut by the end of 2020. It might be tempting to gloss over the yield curve in this situation, especially while other indicators of market health—like credit spreads and balance sheet quality—are pointing to a relatively benign outlook. But the empirical power of the yield curve does have historical validity, and while there are plenty of theories about why this time is different, these theories are untested because there are no other periods that can emulate the extraordinary nature of monetary policy in the decade following the GFC.
Source: Bloomberg, Lonsec
One measure of the yield curve is the spread between 2-year and 10-year Treasury yields. Historically, when this spread has been very low or negative, an economic slowdown and a downturn in equities has followed within 18 to 24 months. As the chart above shows, a negative spread has proved a reliable indicator of economic as well as equities downturns in recent times. For those arguing that the yield curve is now less relevant than it has been in the past, the onus lies on them to explain why this relationship has broken down. Of course, only time will tell if things really are different this time around.
This article has been prepared for licensed financial advisers only. It is not intended for use by retail clients (as defined in the Corporations Act 2001) or any other persons. This information is directed to and prepared for Australian residents only. This information may constitute general advice. It has been prepared without taking account of an investor’s objectives, financial situation or needs and because of that an investor should, before acting on the advice, consider the appropriateness of the advice having regard to their personal objectives, financial situation and needs.
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