The Inverted Yield Curve Part Two: Time to Batten Down the Hatches?
Having preceded every economic downturn in the United States since the 1960s, the inverted yield curve heralds the reputation of being the most reliable signal of a looming recession
In our last Insight article, titled The Inverted Yield Curve: a Recession Precursor?, we explained the remarkable predictive powers of the yield curve and cautioned that winter may be coming for the global economy if this record was to continue. Last week, the first part of the yield curve inverted – so is now the time to batten down the hatches and brace ourselves for a crash?
To answer this question, it is first worth understanding what caused the inversion:
What caused the inversion?
Last Monday, the short end of the US Treasury yield curve inverted, meaning that the 2 year Treasury note yield exceeded that of the 5 year. This happened after Jerome Powell, Chair of the US Federal Reserve, commented that the central bank’s benchmark interest rate is “just below” neutral, versus previous guidance that the Fed was a “long way” from it. This more dovish shift in tone slashed market expectations for the pace of additional rate hikes.
“Interest rates are still low by historical standards and they remain just below the broad range of estimates of the level that would be neutral for the economy – that is, neither speeding up nor slowing down growth.” (Powell, 28th November 2018)
“Interest rates are still accommodative, but we're gradually moving to a place where they will be neutral… We may go past neutral, but we're a long way from neutral at this point, probably.” (Powell, 3rd October 2018)
Consequently, with the renewed expectation that the hiking cycle may conclude as early as next year, coupled with growing concerns of an economic slowdown on the horizon, there was a shift in the yields of US debt leading to the belly of the curve (3 to 7 year maturities) outperforming the short end and inverting.
Source: Bloomberg, Waverton. Data from 07.01.00 to 10.12.18
What does it mean?
If this trend continues – which there is no certainty of – the more widely monitored 2s10s curve (that reads as ‘the difference in yield between a 10 year and a 2 year Treasury note’) will invert in the next 3 months. Over the last 50 years, this indicator has a 100% record of predicting recessions, with the last false signal occurring in 1966. The average time lag between an inversion and a recession, however, is 12 to 18 months, so the inversion may not be an immediate signal to de-risk.
It is worth adding that this latest move largely came on the back of comments Jerome Powell made during a speech to The Economic Club of New York. What the market took from these comments may not actually be what was intended by the Chairman and it is entirely possible that Powell could backtrack on his dovish comments at the next FOMC (Federal Open Market Committee – the committee responsible for setting the central bank benchmark rate) press conference next week. After all, this wouldn’t be the first time a policy maker has said one thing and meant another. September’s FOMC meeting gave a prediction of 3 to 4 hikes in 2019 and the market is now pricing in 1 hike, so this next official reading will be significant in clarifying the current stance.
Moreover, from an economic strength perspective, US economic growth may be showing some signs of slowing, but we are still far away from a contraction. As of October, the Conference Board US Leading Index Ten Economic Indicators (“LEI”), which tends to move before changes in the overall economy, still had a positive trajectory. Note from the below that the LEI Index peaked in March 2006, almost 2 years before the US entered recession.
Source: Bloomberg, Waverton. Data from 29.12.00 to 31.10.18
In conclusion, last week’s inversion in the short end of the US Treasury yield curve is a major indication that we are late in the economic cycle, normally associated with a flatter yield curve. Nonetheless, economic data continues to contradict signs of a looming recession and history tells us that there is a sizable lead time between an inversion and recession in any case. For these reasons, we prefer to wait for further evidence before adopting a more defensive stance in client portfolios, especially after a de-rating of equities.
By James Carter
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.
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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.