Inverted Yield Curve: What does it mean for the U.S. market?

Yield Curve Explained

Fears of a recession were triggered last week when the yields on 2-year and 10-year Treasury notes inverted for the first time since 2007[1]. The yield curve shows the relationship between the interest rate of a bond and its time to maturity. In normal conditions, the yield curve slopes upwards from left to right as investors demand a higher rate of interest on bonds with a longer maturity. This is due to investors preferring having money today to having money in the future, thus they demand a higher rate of return for having to wait for their money. An inverted yield curve occurs when this relationship doesn’t hold, and the interest rate is higher on short term bonds than it is on long term bonds. This signals that investors are worried about the near-term prospects of the economy. It shows demand for long term bonds has risen, suggesting investors want to lock in long term yields now, as they fear yields will be lower in the future due to low inflation or possibly deflation, caused by a recession[2].

While other parts of the yield curve have already inverted, this was the first time since 2007 that the relationship between the 2-year and 10-year Treasury yields inverted. This was particularly worrying as the predictive powers of this inversion are well documented. An analysis by Credit Suisse, which examined data on the yield curve going back to 1978, found that the last five 2-10 inversions have all led to recessions eventually. This has occurred on average 22 months following the inversion. However, their analysis also showed that the stock market may perform well in the short run. They found the S&P 500 was up 12% on average a year after a 2-10 inversion and it takes 18 months on average for the stock market to begin to decline[3].

Different this time?

John Templeton famously said that the four most dangerous words in investing are “This time, it’s different”. However, this has not stopped many commentators claiming that this time the inverted yield curve does not signal an oncoming recession. Mohamed El-Erian, the chief economic adviser at Allianz said the bond market is distorted due to the loose monetary policy in Europe. “If you live in an interconnected world, you have no choice but to import the effect of negative policy rates in Europe.” he claimed, going on to say “That is going to distort our yield curve. And it’s going to weaken the traditional signalling mechanism”[4]. Another explanation was given by Kansas City Fed President Esther George who said the Federal Reserve may be responsible for the inversion. “I think the Fed still has a large balance sheet, and that could be putting some downward pressure on those longer-term rates,” George said, also saying she thought this time it didn’t signal a recession[5]. Investors should be careful about taking too much comfort from these comments as similar claims about the yield curve inversions not predicting recessions were made by then-Fed Chairmen Ben Bernanke before the last recession[6].

Risks to the Global economy

Currently, data on the US economy seems to support the narrative that the yield curve is not pointing towards a recession. Growth in the U.S economy slowed in the second quarter, but it still posted a respectable growth rate of 2.1%. Additionally, unemployment remains low and wages continue to grow[7]. On the other hand, the outlook for the global economy is beginning to look shaky. Many other countries yield curves have also inverted, such as the UK’s and Germany’s[8]. In these countries, economic growth is less robust, with the UK’s economy slowing and being threatened by the prospect of a no-deal Brexit, while the German economy is slipping into negative growth[9]. This, along with political issues in Argentina and Hong Kong, and the increasing US-China trade tensions, seems to be combining to create a poor outlook for global growth, which could begin to affect the U.S economy. Indeed, the one area of the U.S economy where there is weakness is in manufacturing, which recently began to contract for the first time since 2009 due to the effects of the US-China trade war[10].

Adding to these fears is the possibility of Fed policy mistakes. The yield curve inverted again on Wednesday, when the Fed released the minutes of its last meeting, where officials said that their move to lower interest rate three weeks ago shouldn’t be seen as part of a “pre-set course” for future cuts. This has created fears that the Fed will not do enough to save the economy from a recession[11].

Conclusion

While it does not seem like a US recession is a foregone conclusion, the inversion of the yield curve and the threats to global growth make it a possible event. With the current equity bull market being the longest in history and valuations being high by historical standards[12], investors should be wary as there is potential for a large fall in the stock market from a recession or a slowdown in U.S. growth.