It may have been a short-lived and modest intra-day move, but the fact that the 10-year US treasury bond yield briefly fell below the yield on the two-year US treasury note on Wednesday – coming amid a broad equity market sell-off and continued uncertainty over trade tensions between the US and China – has the markets more nervous of another crash.
Jim Reid, Deutsche
Jim Reid, research strategist at Deutsche Bank, is on holiday but spent most of his day in communication with colleagues in the office, before sharing his worries with clients.
“Although other measures of the US yield curve have progressively inverted over the last few quarters, for me yesterday’s 2s/10s inversion is the one that worries me most,” he told them.
“In my opinion, it has the best track record for predicting an upcoming recession over more cycles than any of the others. Indeed, every inversion since 1956 has seen a recession follow. Although the median length of time to a recession is 17 months, credit spreads have pretty much exclusively widened from the point of inversion onwards.”
Mark Haefele, global chief investment officer at UBS wealth management, is far from panicking yet. He, along with others, point out that the Federal Reserve may yet save the day by cutting rates sharply.
For all the nonsense about a mid-cycle adjustment, expectations are already baking in of further rate cuts, perhaps 50 basis points in September and more before the end of the year.
“The length of time the yield curve is inverted, and how much is inverted, matter,” Haefele says. “If Fed rate cuts successfully steepen the curve comfortably into positive territory, this brief curve inversion may be a premature recession signal.
“Neither does a yield curve inversion indicate it is time to sell equities. Since 1975, after an inversion in the two-year/10-year yield curve, the S&P 500 has continued to rally for nearly two years, and has risen by 40% on average until hitting a bull market peak.”
Deutsche’s Reid agrees that in two out of the nine recessions since the 1950s that have followed such an inversion, the delay until the recession arrived has been more than two years. For example, following the May 1998 inversion, it took 34 months until a recession arose.
That inversion was relatively brief and occurred just before the Russian/LTCM crisis where the Fed rapidly cut 75bp and thus re-steepened the curve. The Fed then raised rates again from 1999 and the curve re-inverted in early 2000, around a year before the actual recession.
However, Reid warns: “Given that the market already prices in 65bp of cuts before year-end, it feels like they might need to out-pace that to make it three out of 10 where they’ve delayed the recession.”
US rates have risen from the lows of the quantitative easing (QE) era, but are still low by historical standards and by the end of yesterday the 10-year bond yield had recovered to be essentially flat against the two-year.
We don’t think the Bank of England would raise interest rates to protect sterling from further damage and mitigate the inflation shock, so things could get messy quite quickly- Thomas Wells, Smith & Williamson
Have years of extraordinary monetary policy perhaps dulled the predictive power of such an inversion?
Reid says: “I don’t think this time is different because of term premium being much lower and global QE etc, as we think the causality is through animal spirits. In an inverted yield curve environment, this gets increasingly drained and thus impacts financial and economic activity.
“So, I really don’t care why the curve inverts, just that it does.”
While attention focuses on the US government bond market, warning signs are flashing elsewhere too.
John Velis, FX and macro strategist at BNY Mellon, says that beyond the actual inversion itself, just as worrying are its drivers. The long end of the curve – ie the 10-year bond yield – has fallen sharply over the course of the year.
Velis says: “Global growth and inflation expectations have fallen around the world in response to growing policy uncertainty, as well as fading momentum in aggregate demand.
“In the past, yield curve inversions usually occur when the short end of the curve – which proxies monetary policy rate expectations – rises above the long end.”
That is the model of excessive central bank tightening leading to a recession.
“This time around, the long end has fallen more than the short end has risen, and the collapse in 10-year yields is not just confined to the US,” says Velis.
“Even in economies like Germany, which have endured extraordinarily low yields for some time, growth and inflation expectations have worsened, leading yields even lower at the long end of the curve.”
Misery likes company and the US and Europe may not face the worst of it, however.
Thomas Wells, manager of the Smith & Williamson global inflation-linked bond fund, points to the obvious and particular dangers in the UK.
“The market seems to be waking up to the risk of a no-deal Brexit, as the front end of the UK yield curve is now inverted, with five-year gilts offering lower yields than two-year gilts,” he says. “An inverted yield curve is by no means a perfect indicator of a recession, but in our opinion the risks to growth are now firmly tilted to the downside.
“Even without Brexit, it is clear that global growth is slowing, so the timing of a potential no-deal scenario in October could hardly be worse.”
And in just the last 24 hours, the yield on the 10-year gilt has dropped below the two-year, although it remains above the five-year. One week ago, the 10s were still yielding about 5bp above the fives, and one month ago that spread was almost 25bp.
The biggest danger is for the currency, according to Wells.
“It is not impossible that we will see weaker GDP data and higher inflation in Q4 and into Q1 2020 if there is no deal and the currency is subject to further downward pressure,” he says.
“We don’t think the Bank of England would raise interest rates to protect sterling from further damage and mitigate the inflation shock, so things could get messy quite quickly.”