For the first time in more than a decade, the US treasury yield curve inverts as investors react with fear causing the major indices; Dow Jones Industrial Average, the S&P 500, and the Nasdaq to close down 1.8%, 1.9%, and 2.5% respectively.
The yield curve—the difference between the yields on longer-term and shorter-term Treasuries— is one of the economy’s most reliable warning lights started flashing more frantically last Friday.
What is the yield curve?
The yield curve has always been a key economic indicator used to predict recessions. The US yield curve – is based on AAA-rated US Government bonds, or also known as US Treasuries – is a reflection of the relationship between short-term and long-term government bonds.
Here’s how the yield curve works: When investors buy bonds, they are lending the government money. The government then pays back interest on that money each year and returns the full amount to investors when the bond reaches maturity.
Typically the government pays a higher annual interest rate for long-term bonds than short-term bonds because the government borrows money for a longer period of time. For example, investors will receive 3% per annum coupon for a 10 year treasury note versus a 2 year note that pays 2% per annum.
A “normal” yield curve is one in which shorter-term bonds yield lower than longer-term bonds. This reflects the additional risk that an investor takes for holding longer-term bonds. This relationship produces an upward sloping yield curve.
Why do investors look at the yield curve?
Normally, yield curves slope upwards as investors demand higher rates to compensate for risk over longer time horizons. An upward sloping curve also reflects expectations that economic growth will continue.
So when the curve inverts, it means that investors are less certain that growth will continue. In other words, investors are predicting that the economy is going to slow down. This sentiment is reflected in the bond markets as investors bid-up long-term bonds – thus driving down their yields – because they are pessimistic about the short-term prospects for the economy.
When the yield curve inverts, borrowing costs in the near-term are more expensive than the longer term. Therefore, it would be more costly for businesses to expand their operations. Meanwhile, consumer borrowing could also fall, thus leading to lesser consumer spending in the economy. All of these could lead to a subsequent contraction in the economy and a rise in unemployment.
In other words, a future recession.
Is the yield curve a predictor of recessions?
Here, we take a look at the spread between the 10 year minus 2 year treasury notes – regarded as the predictor of recessions. The spread shows the interest rate differential between the two treasury notes. Readings above the black line implies that 10 year yields are higher than 2 years (upward sloping curve), while readings below the black line implies that 10 year yields are lower than 2 years (inverted curve). The chart also showed periods of economic recessions highlighted in grey.
As you can see, prior to each recession since the 1980, the yield curve inverts for several consecutive quarters ahead for the economic slowdown. It almost look like clockwork.
We can certainly use the yield curve to predict whether or not the economy will be in a recession at a given point in the future.
However, it might not be advisable to take these predictions as absolutes. Researchers have suggests that the main drivers of the yield spread today are different from the determinants that generated yield spreads during prior decades. Differences could be due to changes in international capital flows, monetary policy and inflation expectations etc. The bottom line is that yield curves helps us understand the business cycle, but, like other indicators, should be interpreted with caution.
Should investors be concerned about the inverted yield curve?
The financial markets always factor into FED decisions. In recent comments by FED chairman, the FOMC forecast that no further rate hikes will be coming this year, this comes after its members indicated that two were likely as recently as December 2018. This decision obviously spooked bond market investors who became anxious about near-term economic growth.
There are valid concerns of a recession eg; the US-China trade war, the fading effects of fiscal stimulus from the Trump tax plan or concerns on the country’s ballooning deficit – it is best to take a step back.
Since its peak in Dec 2013, the 10yr – 2yr spread has aggressively flattened and the yield curve is signaling slower economic growth for the US, but not yet a recession.
As we know, past yield curve inversions that have preceded recessions tends to last for several consecutive quarters. This is largely due to the trickle down effect on the economy. If short-term borrowing cost persists to remain higher than the long-term, businesses will need time to react to these changes.
In fact, if history is any guide, investors should remain calm in the near term. Historically, stocks rose about 15 percent on average in the 18 months following inversions, according to a Credit Suisse analysis last year. The data also showed that the stock market tends to turn sour about 24 months after the yield curve inverts. Three years after an inversion, the S&P 500 is up just 2 percent on average as stocks take a hit on recession fears.
While this is not a recommendation to go long on stocks now, there is still plenty of time for investors to position their portfolios to weather a potential economic downturn.
Another factor to note is the spread between non-investment grade bonds and the spot treasury curve (High-yield bond spread).
A high yield bond or junk bond, offers a higher rate of interest due to the additional credit-risk taken by investors. Due to its greater risk of default, these bonds have a lower credit rating than government bonds or investment-grade bonds. Hence, to draw interest, its issuers offer attractive interest rates to investors.
High-yield spreads are typically used to evaluate the overall credit markets. In a risk-on environment, investors are more willing to purchase high-yield bonds because economic conditions are strong and growing. This means that issuers of high yield debt (companies), are less likely to default of their debt. Conversely, in a risk-off environment, investors tend to avoid high-yield bonds due to riskier conditions and allocate capital into safe-havens instead (govt bonds).
Not too long ago when oil prices were in a slump, it affected the creditworthiness of many oil related companies. As a result, the high yield spread widen as shown in the chart above.
In the last 20 years, there were 4 major events that caused a spike in the high-yield spread. 1st was the period after the 9-11 attacks, 2nd was the 2008 subprime crisis, 3rd was the Eurozone credit crisis and most recent, was when oil prices crashed in 2015.
Presently, the high-yield spread has not shown any signs of mass credit-default which implies that companies are still in good financial position. There are 2 possible catalyst that will cause a spike in the high-yield spread, 1 – short-term rates continue to yield higher than long-term, which means cost of capital becomes more expensive. 2 – Worldwide economic conditions deteriorate due to trade tensions etc. In these two scenarios, we will see a spike in the high-yield spread.
What are the signs that we can lookout for ahead of a recession?
A key factor to note is business conditions; lookout for economic indicators such as PMI, Durable Good Orders and Industrial Production. These indicators measures business activities and growth in the US. A growing number means that companies are actively investing and expanding their businesses, while a declining number will suggest otherwise.
The ISM Manufacturing PMI in the US fell to 54.2 in February of 2019 from 56.6 in January, below market expectations of 55.5. The reading pointed to the slowest growth in factory activity since November of 2016 as new orders, production and employment increased less.
The ISM Non-Manufacturing PMI index for the United States jumped to 59.7 in February of 2019 from 56.7 in January, beating market expectations of 57.3. The reading pointed to the strongest expansion in the services sector in three months, as business activity, new orders and employment rose faster. Service providers remained mostly optimistic about overall business conditions and the economy but showed concerns about the uncertainty of tariffs, capacity constraints and employment resources.
The ISM Non-Manufacturing Index provides a detailed view of the U.S. economy from a non-manufacturing standpoint. The index provides information about factors that affect total economic growth and inflation. When used alongside the ISM Manufacturing Report, the industry coverage between the two reports accounts for almost 90 percent of the GDP.
While the yield curve can signal that the risk of recession is rising, investors still have plenty of time to prepare for a potential recession. Foreseeing the bumpy road ahead, investors can consider buying more consumer discretionary stocks and position their portfolios towards defensive sectors like utilities and health care.
The recent inversion of the yield curve is interesting but, in my view, it does not necessarily signal that recession is near. We would need to see a further sustained inversion of the curve along with deterioration in business conditions before we would become truly worried. Stay tuned.