Inverted yield curve: a recession indicator?
On the surface, investors cannot be blamed for fearing a looming recession. Earlier in August illustrated clear “risk-off” sentiment. Equity markets contracted and fixed income yields were driven down as trade uncertainties globally remained elevated and outside the US, economic growth appeared to be mild and weakening.
One of the predictors of recession that is closely watched is the yield curve. The 2-year and 10-year segment of the US yield curve inverted earlier in August. In the past, when the longer end of the yield curve is lower than the short end, this has been followed by a recession at some point. While this signal has now flashed in the US, a recession looks far from inevitable in the short term.
The curve tends to invert at the end of a hiking cycle. This is because the short end of the curve is anchored to the central bank rate. In the latest case, the short end was responsible for the flattening (a so-called bear flattening) of the curve but not the inversion, which was caused by the recent yield rally in the long end (or a so-called bull flattening).
Long-end curve positioning
The level of the long end of the yield curve is a result of positioning by investors that are trying to anticipate the long-term neutral rate. Two important factors are driving this positioning.
Firstly, a structural change in investors’ positioning is evident by the secular trend of ever-lower yields in recent decades. While the term premium has been depressed by substantial quantitative easing by the US Federal Reserve (Fed) since the financial crisis, it has also been driven lower by investors having less aversion to holding longer-dated bonds. This reduced aversion may be due to diminishing fears of unexpected events occurring, such as a surprise changing in Fed policy, or simply that investors prefer or need to put cash into the market at any price or yield level.
Secondly, rates are being driven by fear of recession. As mentioned, bond investors are trying to anticipate what could happen, with many believing the US central bank will persist with generous asset-purchase programmes. This is leading bond investors to become desperate to “lock in yields before they get worse”, given yields are so close at the zero mark.
Desperation can lead to extreme positioning. In the past, investors would first have wanted more evidence of a recession before going into longer-dated bonds. It is worth noting that this leads to weaker prediction characteristics with regards to the yield curve inverting. Note that the 170 basis points contraction in 10-year US yields in the last 12 months has rarely been seen in the past without an actual event, or worsening economic data, triggering such a move.
Implications for investors
While the US yield curve inverted this month, fear and anticipation as opposed to fundamentals appear to be driving the current move in the long end. That said, investors should not base decisions of one distorted data point but rather a thorough analysis of the market and the economy.
Even if the inverted yield curve is taken at face value, it should be noted that, on average, the S&P 500 has returned 13% in the periods between an inversion and a recession.
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