The Inverted Yield Curve: a Recession Precursor?

Used as a crystal ball by economists, the yield curve has a strong track record for predicting recessions. Whilst it probably isn't "different this time", an inversion itself isn't an immediate sell-signal.

The yield curve plots the investment returns of similar bonds against their maturities, at a set point in time, ranging from the shortest to the longest. The curve’s shape changes over time and may take three forms:

1. Upward sloping: short-term yields are lower than long-term yields

2. Little to no difference between short- and long-term yields

3. Downward sloping (inverted): short-term yields are higher than long-term yields

Normally the curve is upward sloping [scenario 1], which means that you get a higher return for investing for longer periods – known as a term premium. Simply put, investors require a higher return for the added unpredictability of lending for longer periods of time. In contrast, an inversion of the yield curve [scenario 3] is where the yields on short-dated bonds are higher than long-dated bonds and, therefore, there is a negative term spread.

Such an inversion of the US Treasury yield curve usually occurs when the market predicts lower interest rates in the future, most likely due to the expectation that the central bank will reduce interest rates to soften the impact of an economic slowdown. Thus, an inverted yield curve typically suggests a bearish stock market ahead and is a precursor for a recession.

Today, the term spread between 2- and 10-year US Treasuries is at its lowest level since 2007. The spread has fallen from 274bps at its 2010 peak, to 0.24%. This is a relatively flat yield curve [scenario 2] and, following its current trajectory, the yield curve could invert in early 2019.

The chart below shows the term spread between 2- and 10-year US Treasuries (top line chart) since 1978 and the Conference Board Leading Economic Index YoY% (“LEI”) (bottom line chart), a proxy to forecast economic activity. The grey shaded areas indicate recessions and the purple shaded areas indicate the lag between a yield curve inverting and next recession:

Graph to show term spread between 2- and 10-year US Treasuries since 1978 and the Conference Board Leading Economic Index YoY%

Source: Bloomberg, NBER, Waverton

Whilst an inversion has preceded every recession during this time, there is a sizable lead time (as the purple shaded areas show). Inversion has occurred on average 15 months before the 5 recessions since 1978. Below is a summary table:

Inversion

Recession

Lead (months)

Aug-78

Jan-80

17

Sep-80

Jul-81

10

Jan-89

Jul-90

19

Feb-00

Mar-01

13

Jun-06

Dec-07

18

 

Average

15.4

The current shape of the yield curve is primarily a result of the Fed hiking short-term interest rates in response to a potentially overheating economy. The Fed are guiding the markets to expect another two hikes in 2018 and more in 2019. These rate hike expectations get priced into the short-end of the curve and, consequently, yields increase faster than in the long-end, which tends to rise more slowly. Longer-term Treasury prices are more difficult to manipulate, however, and are more influenced by forecasts for inflation and growth. Hence, the risks of a trade war, which might weaken growth, would be more priced in here.

In summary, our take on the flattening of the curve is the following:

1. In the short term, investors are positive on the economy and expect the Fed to continue rising rates, leading to 2-year yields increasing.

2. In the longer-term, investors are mindful of modest inflationary pressures and a possible global slowdown which has kept 10-year yields from increasing at the same rate.

3. Although the market is fearful of a slow-down, the risk is not immediate. The Leading Economic Indicator is not dropping, as it has done prior to each recession. Even if the curve does invert we should still have a lengthy window to prepare for the recession it may be signalling.

Whilst it probably isn’t “different this time”, it should be noted that the curve has not yet inverted and it may be that, like in Dec-94 and Jul-98, it steepens from here. Although curve inversions are a reliable indicator for a recession, history tells us that flattening trends can be reversed.

Thus, the flattening curve is not necessarily a harbinger of a big slowdown. And even if the curve does invert, Canaccord note that the S&P 500 rose for an average of 18.5 months and saw a median gain of 21% from the day of the inversion to the market peak. We still think it remains likely that we will see above trend growth in the U.S. this year and into next, but we are clearly in late-cycle territory (a 10-year expansionary cycle has only happened once post-WWII). Consequently, we will continue to closely monitor this indicator, and others, to help us to determine where we are in the economic cycle. After all, as Gordon Brown discovered, no one is bigger than the business cycle.

By James Carter

 

Risk Warning

 

The views and opinions expressed are the views of Waverton Investment Management Limited and are subject to change based on market and other conditions.  The information provided does not constitute investment advice and it should not be relied on as such.  All material(s) have been obtained from sources believed to be reliable, but its accuracy is not guaranteed.  There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.

Changes in rates of exchange may have an adverse effect on the value, price or income of an investment.

Past performance is no guarantee of future results and the value of such investments and their strategies may fall as well as rise.  Capital security is not guaranteed

The information relating to ‘yield’ is for indicative purposes only.  You should note that yields on investments may fall or rise dependent on the performance of the underlying investment and more specifically the performance of the financial markets.  As such, no warranty can be given that the expressed yields will consistently attain such levels over any given period.