Markets took a brutal pounding August 14 as major stock indexes declined by or about 3%, mostly in reaction to an official inversion of the 2-year versus 10-year yield curve. Specifically, at the outset of the day’s trading, the 10-year U.S. Treasury bond dropped to a yield lower than the 2-year bond, which has been historically interpreted as a harbinger to an upcoming recession. Therefore, stocks sold off fiercely on this premise of potentially deteriorating economic conditions and what that could mean for corporate profits and the overall market environment. The day closed with the 2- and 10-year Treasury bonds essentially flat with one another, both at 1.58%.
Important points of consideration include:
Why is an inverted yield curve believed to be a precursor to a recession?
The theory behind the predictive power of an inverted curve is that as the bond market identifies the economy slowing materially, longer-term bonds will increase in demand as investors look to lock in future yields on the expectation they will continue to fall as economic growth declines. Traders will also seek higher-duration bonds as they will experience greater price increases as rates fall. As a result, the balance of demand will cause longer-term bond yields to fall below short-term yields.
How historically accurate have inverted yield curves been in forecasting recessions?
One might say inverted yield curves have been accurate almost to a fault in that they have correctly forecast seven of the past five recessions. In other words, pretty much all modern day recessions have been preceded by inverted yield curves, but not all inverted yield curves have been proceeded by recessions. Most would argue inverted curves correctly warned the market about upcoming recessions in 1980, 1981, 1990, 2001, and 2008. However in our opinion, strong arguments can be made that false alarms were flashed by inverted curves in 1998 and 2005.
Why would the recent curve be inverted for reasons other than predicting a recession?
For more than any other reason, we believe the curve could be inverted due to historically anomalous negative yields in other regions of the world that, in our opinion, are bordering on bizarre and absurd. Currently, more than $15 trillion of sovereign debt throughout the globe is providing negative yields to investors. This includes 10-year rates in Japan of -0.25% and in Germany of -0.65%. (To put this in practical terms, if you were to buy a $1,000 bond in Germany, you would be guaranteed to receive only $940 in 10 years). In Europe alone, four countries (Germany, France, Netherlands, and Switzerland) are sporting negative 10-year yields, with three others (Portugal, Spain, and the U.K.) only barely positive. So in our opinion, capital is likely flocking into the U.S. Treasury market where yields, on a comparative basis, look high, and this is creating a historically strong demand for longer-term U.S. bonds, which in turn is suppressing yields and thus inverting the curve for reasons unrelated to the economy.
Why are rates in other regions of the world negative?
In our opinion, it is due to a combination of slowing economic growth in certain regions such as Europe and Japan, a lack of inflation, and global central banks that have mistakenly pushed their monetary policies too far in attempting to resolve these conditions. As a result, bond investors in these countries are increasingly looking to the U.S. to provide yield, and this is reflected in the U.S. 10-year Treasury yield which has declined 0.55% (from 2.13% to 1.58%) since mid-July.
What does this mean for future short-term rates and Federal Reserve policy?
We are strong believers that the Fed does not like inverted yield curves as it fears they could lead to self-fulfilling investor and consumer behavior as well as painful reminders as to what happened during previous pre-recession cycles. Therefore, we believe this current inversion, along with the 3-month-to-10-year inverted curve that has been in place since June, increases the likelihood and magnitude of future rate cuts between now and year-end. This is consistent with the mini-easing cycle we believed went into effect last month, and it will likely continue until we see a lower bound on the Fed Funds target range of perhaps 1.50%, or 0.50% below the current level. Market expectations of lower Fed Funds rates have recently escalated and presently reflect near certainty of at least a 0.25% reduction and about a 50% probability of up to 0.75% by the end of 2019. In addition to concerns of the ongoing U.S.-China trade dispute and a lack of inflation, the Fed will likely see lower short-term rates as the most efficient means to steepen the curve.
Where do we stand on all of this?
We do not believe the U.S. economy will experience a recession in the foreseeable future and while the current state of the yield curve is concerning and worthy of close attention, the recent inversion is more the result of negative overseas interest rates rather than economic forecasting. Reasons for this perspective include:
- U.S. gross domestic product (GDP) completed 1H19 at a pace of 2.6% and 3Q looks to be tracking at close to 2% so far. This is a long way from two consecutive quarters of negative growth that is the definition of recession.
- Consumer spending, which ultimately accounts for about two-thirds of economic growth, remains strong and is trending above the broader GDP pace.
- The lower level we are now seeing in longer-term rates and will likely continue seeing at the short end could very well have a noticeably favorable impact on consumer behavior as seen in areas such as mortgage refinancing and other activities leading to higher disposable income. This could help to provide a buffer amid increasing nervousness of a slowing economy.
- The U.S.-China trade dispute, while a primary culprit of market volatility and investor angst, can still potentially be resolved through negotiations in the months ahead and, if so, we believe enhanced economic sentiment would quickly follow.
- Finally, should such an agreement be reached in the next few months, we believe this could open the door for strong opportunities in the equity and credit markets in 2020 based in large part on the clearing economic obstacles and more favorable valuations the lower rate environment can help to provide.
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