US yield-curve inversion: is this time different?
With much of the US Treasury yield curve recently inverted, including the first inversion of the 10 year-to-three month part of the curve in 12 years, fears of a US recession have risen.
The slope of the US Treasury yield curve has proved to be one of the most reliable predictors of future economic activity. An inverted yield curve (when short-term yields are higher than long-term ones) has correctly signalled all nine recessions since 1955 and only sent one false signal, in 1966. Strikingly, while each recession has been different, patterns in yield curve inversion have been remarkably similar each time.
Nonetheless, there remain important uncertainties. First of all, what causes what? Does the fear of a recession encourage market participants to buy long-term bonds for protection, thus sparking yield curve inversion, or does the buying of long-term bonds trigger recession by tightening financial conditions—a so-called self-fulfilling prophecy? In other words, is this time different? This is an open debate.
“Our own model suggests that there is now a 43% chance of seing the US economy entering a recession in the next 15 months.”
Another popular measure is the percentage of the US yield curve that is negative. After a rapid increase in this percentage in the last nine months, by mid-September our own model was suggesting a 43% chance of seeing the US economy entering a recession in the next 15 months.
Other measures of the yield curve slope have also been used to forecast recessions, in particular the 10-year to two-year Treasury spread, seen as the best indicator of the effectiveness of monetary policy by market participants. The fact that the short end of the US Treasury yield curve is stuck near the fed funds rate level may mean that the recent inversion is due to the Fed not being aggressive enough in cutting rates relative to the fall in the 10-year Treasury yield. Set alongside market expectations of additional cuts in policy rates by the end of 2020 and the recent faltering of the US growth outlook, the recent fall in Treasury yields comes as no surprise when looked at from this angle.
Another sign of market participants’ increased fears of a US recession is the subdued inflation expectations imbedded in the 10-year yield (the so-called inflation breakeven yield). While already low at the start of the year, expectations have fallen further since then.
As the rise in prices (specifically core inflation) looks like being limited, we expect the Fed to continue to cut rates once more this year and to maintain a dovish bias going into 2020. Along with the ongoing trade war uncertainty, this should push the 10-year Treasury yield down towards 1.4% by year’s end. We would expect it to move back to 2% only if the Trump administration were to remove most of the announced and existing US tariffs on Chinese imports or, more improbably, if the Fed eased rates more aggressively than expected to boost US growth again.
Encompassing all the information available, and applying our own inhouse models, there is a distinct possibility that a recession could strike in 2020. The more investors are convinced of this risk the more likely it will happen. Beware the self-fulfilling prophecy!
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