What is the yield curve’s success in predicting previous US recessions?
Evidence on yield curve inversions is mixed. While they have often preceded recessions in the past, there have been some false signals such as 1998 during the Asian crisis when investors rushed for the safety of long dated US Treasuries. When it has predicted recession - e.g. in the early 1990s, 2001, 2008, etc - the time lag between inversion and recession has varied between one to three years, with the average being 22 months.
Is the inversion consistent with the US data?
Some parts of the US economy have certainly been on a weakening trend, particularly those sectors that are more exposed to escalating trades tensions such as investment and export orders. Against, that, the consumer sector remains buoyant, as does small and medium-sized business confidence which is more attuned to domestic economic conditions. Furthermore, credit growth to corporates is holding up well and there is no real sign of worrisome imbalances or bubbles in housing or the banking sector than have been the harbinger of previous recessions.
What other reasons could be causing the inversion?
The recent inversion has mainly been driven by a rally in 10-year yields rather than a rise in 2-year yields which has characterised many previous inversions and that would ordinarily suggest that Fed policy had become too restrictive. The more likely explanation is that the rally in longer-dated US Treasuries has been driven by global influences such as global trade concerns and the reach for yield that seems to pervade all bond markets these days. Put simply, when the German 10-year government bond is yielding -0.6%, a yield of 2% in the US against a backdrop of global economic concerns looks attractive. Add to that concerns that central banks don’t have sufficient tools to fight the next recession and it is plain to see how bond markets end up in a self-fulfilling vortex lower bond yields and increasing concerns over growth.
What could be the gamechanger?
A short-term correction could just come down to a tweet from the US President on trade, better data, or market positioning. A bigger and more durable gamechanger would be a more permanent thawing in US-China trade tensions or extensive trade deal complete with a rolling back of tariffs; significant China stimulus; or, a relaxation of fiscal constraints in Europe. Headlines recently suggest that Germany may be prepared to loosen the purse strings to counter recession risks.
In conclusion, while there is certainly some value in observing relative moves in the yield curve, an actual inversion event does not in and of itself signal imminent recession. Economic risks are growing, mainly as a consequence of escalating trade tensions but the US economy for the most part remains in good shape. We believe it is not a time to chase ever lower yields which justifies some caution when it comes to duration exposure. In this environment, there is still good value to be found in selective EM markets where real yields (once inflation expectations are stripped out) look, on the whole, quite attractive in my opinion.