This situation has occurred several times in August 2019, as the yield on the 10-year US Treasury Bond fell below the yield on the two-year Treasury Bond, the most popular long term/short term yield comparison. The yield curve inversion was the first in a decade. This indicates that investors are concerned about the health of the economy and are no longer demanding a higher yield for longer term investments. The difference between the two-year yield and the ten-year yield over the past 30 years is shown in the table below (periods of recession are shaded in grey).
Source: FRED Economic Data
The inversion of the yield curve at the end of August was due to expectations that slowing global growth will be further hamstrung by the escalating trade war, tipping the global economy into recession and the hitherto robust US economy as well. There is little argument that the inverted yield curve has historically been an accurate indicator of a US recession, successfully predicting the last seven. The last time the yield curve inverted was in 2007, preceding the GFC in the following year. Whilst the yield curve has historically been an accurate predictor of future recessions, it typically occurs 12-18 months before the economy is officially deemed to be in recession. The yield curve may have recently inverted due to factors such as the increasingly likelihood that more quantitative easing may be needed (central banks have announced they are willing to do “whatever it takes” to support the economy) or increasing investor demand for bonds as a safe-haven investment, the latter has the effect of driving down bond yields globally (the probability of inversion is higher when rates are low).
What must be noted in the lead-up to most recessions (as was the case for each of the last seven in the US) is that the economic environment is one of rising inflation and, as a consequence, tightening monetary policy. Over-investment and excessive debt also contributed to these recessions. Whilst interest rates in the US tightened from 2015 to 2018 before easing somewhat, they continue to remain low by historical standards. Furthermore, interest rates are likely to decrease by a further 0.75% by the first quarter of 2020. If a recession does eventuate in the next 18-24 months, it will not be caused by unfavourable monetary policy settings.
One reason inversions occur is because investors are selling stocks and shifting into (longer-dated) bonds. These investors are not concerned about rising inflation as they expect the economy to slow in the future. Another, albeit related, reason is that investors expect real interest rates to fall and believe the soft returns on offer in the bond market over a longer time horizon are an overwhelmingly attractive alternative to the potential losses in the equity market as the economy risks heading into a recession.
The deepening inversion of the yield curve is reflective of investor scepticism in regards to a timely resolution to the US-China trade war. There is a belief that China can afford to play the “long game” in the hope that US President Donald Trump will be removed from office in a year’s time. China Authorities could potentially mitigate, to a certain extent, the continuing effects of the trade war by increasing stimulus measures to achieve its annual growth target of between 6.0% and 6.5%. On the other hand, Trump and other White House China trade hawks are highly unlikely to have all their concerns addressed in meetings with their Chinese counterparts, leading to a continued stagnation in discussions. A likely consequence is the continued breakdown of talks between the two parties, leading to lower global growth outcomes and continued heightened volatility in global equity markets. This is the scenario that is causing concern to investors, the inverted yield curve is merely a function of this concern.
Inverted yield curves have traditionally been harbingers to recessions in the US, albeit preceding the actual start of the recession by a year or more. This time, however, may be different as central banks are willing and able to employ unconventional tools in addition to the usual accommodative monetary and fiscal measures to stimulate the economy. Furthermore, US economic readings remain solid and the Fed is being coerced by President Trump to cut rates notwithstanding the sound domestic economic landscape, thus allowing such stimulatory measures to work their way through the system before a recession occurs. The elephant in the room, which could usher in a recession, remains the actions of President Trump.
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