Are the yield curve’s predicative powers diminishing?

The US yield curve has inverted before every recorded recession over the last five decades1, however the spate of recent and unconventional monetary policy could potentially be rendering the barometer’s predicative powers obsolete.

March 2019 saw the inversion of the US yield curve, as 10-year US Treasury bond yields fell below those available on their short-dated, three-month counterparts2. But while historically an inverted yield curve has typically been an indicator of a recession, we don’t believe it is time to panic just yet.

Currently, we anticipate that the US economy will grow by 2.1% this year1, as the US labour market remains strong and wages are rising, which in our view is pushing out recession risks until at least into 2020.

Concerns over growth have been spurred on by a number factors. The main ones being the Federal government shut-down earlier this year, the fading impact of 2018’s tax cuts, trade tensions, as well as weak overseas growth, most notably in China, and worries over Brexit.

But foreign economic weakness alone, is unlikely to be sufficient to cause a US recession. Moreover, policy is not that restrictive, and 2020 is an election year, which would tend to suggest that policy tilts towards the supportive.

Nevertheless, the present expansion is on track to be the longest in recent modern history but sustaining above trend growth - as the US did in 2018 - is going to be difficult.

Where do the yield curve’s predictive powers come from?

The shape and slope of the yield curve, plots the interest rates offered by bonds, with the same credit quality - albeit with different maturity dates. It is widely seen as a barometer of the future state of the economy, offering potential insights into what investors believe is going to happen with interest rates.

In practice, it is essential to look at yield curves on an individual currency basis, as there is no such thing as a global yield curve. The optical impression that global bond indices give of short-term rates being higher than long-term, is the result of how these indices are constructed.

In a typical global government bond index, the US accounts for around 50% of the market valueat the short end of the curve (where US rates are higher) while non-US issues account for the bulk of longer-dated bonds in the index (where yields are lower).

The reality is that yields should be compared in a single currency. In that case, in aggregate, global short-term rates remain lower than global long-term rates. While the global expansion might be mature, it is hard to say that global bond yield curves are predicting an imminent recession.

When a single-currency yield curve has a ‘normal’ shape, it indicates that the yields offered by short-dated bonds are lower than those offered by long-dated bonds, and the curve has a slightly skewed concave shape.

This makes sense because one would expect investors to demand higher compensation for putting their money at risk for 20 years than they would for risking it only for a year. This is especially the case if they believe the economy is largely going to do well over time and inflation will increase, as they will then demand compensation to offset inflation’s erosive impact. This compensation for putting money away for longer is often referred to as the ‘term premium’.

The yield curve plots the relationship between the yield and expected time horizon of a bond

A ‘normal’ yield curve:

 

When investors have a less sanguine view of the economy, their view of the future changes, and with it, the shape and slope of the bond yield curve. If investors believe the economy is going to slow down, the expectation is that interest rates will decline over time in order to help revive growth. Accordingly, long-term investors generally aim to lock into the higher interest rates on offer, before yields decline. This leads to greater demand for long-dated as opposed to short-dated bonds and consequently yields on long-dated bonds fall below those of shorter-dated instruments, as can be seen in the graph below.

An inverted yield curve:

 

Therefore, an inverted yield curve has typically been a reliable predictor of a coming recession – including the last one which began in 2008.

Since then, however, central banks the world over have embarked on the largest monetary policy experiment in history, in the form of unprecedented asset purchase programmes and interest rate cuts. This has changed the global financial landscape and left a few question marks over many traditional relationships, including the recession-predicting powers of the yield curve.

Debt and quantitative easing play a major role

The flood of ultra-accommodative monetary policy that has characterised the past 10 years has pushed yields across the curve to historic lows, and in some cases, into negative territory. But in 2017, the global economy seemed to pick itself up off the floor. Sentiment rose, as did corporate earnings, and developed country central banks began turning their attention to unwinding some of this liquidity. Due to this shift in sentiment, yields rose.

Nevertheless, while the economy has improved markedly, inflation remains stubbornly low. So even as the Federal Reserve is increasing short-term interest rates, the lack of inflation has meant that investors have continued to remain buyers of long-term debt, which has helped support prices and thus, keep a lid on yields. This has been exacerbated by the ongoing demand for long-term debt from central banks and insurance companies charged with ensuring that their assets match their liabilities.

The result has been an ongoing flattening of the curve but not because of the reasons which have characterised the move in previous instances.

The other factor that has affected the relationship between the yield curve and the economy is the stock of debt currently sitting on global balance sheets.

One of the goals of quantitative easing was to induce companies to borrow money to invest, which would in turn hopefully revive the struggling global economy – and in that sense, the policy has succeeded. But a side-effect is that debt levels across the world have ratcheted sharply higher. This is fine if borrowing costs remain cheap. However, government bond yields set the benchmark for borrowing costs and if they continue to rise, those companies and countries battling to meet their debts will struggle, which could hit economic growth.

While these factors, and the ever-present wild card that is the current geopolitical environment, make it harder than ever to predict what is likely to happen in the future, the yield curve remains a major port of call for investors assessing financial markets – and this doesn’t look likely to change anytime soon.

1 Source: AXA Investment Managers

Source: Financial Times, ‘Why investors are worried about the yield curve’, 28.03.2019

3 Source: Financial Times, ‘Flat yield curve sends a grim message for investors in 2019’, 20.06.2018

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