Macro

Yield curve inversion assumes centre stage again

Mahesh Sethuraman

Singapore Sales Trader

Summary:  Yield curve inversion is a hot topic in the financial press these days, given its historical role as an indicator of recession. But the timeline for the cause and effect of yield curve inversion vs economic recession/slowdown is rather long and investors have to be wary of reacting to every headline on the topic.


The latest escalation of the US-China trade war has suppressed yields across the developed world as the already gloomy late cycle growth prospects of the global economy will likely get worse. With very little political will in any government in the world for a sustained fiscal stimulus, the central bankers are fighting an unequal battle of gloomy economic reality with pretty much only one worn out tool in their arsenal.

Bond markets are lapping up whatever yields they can get as the dovish expectations from central banks are near unanimous. And with that comes the falling term premiums, the flattening yield curves, and in some cases yield curve inversions too. US 10-year – 3-month spread has squeezed back to more than a negative 10 basis points. The US 10yr-2yr spread is getting increasingly flatter again after a brief respite.

Source: Bloomberg

By now it is quite well established 10-yr – 2-yr Treasury yield inversions have served as strong indicators of an economic recession in the US. So it is no wonder that the market has been obsessed about this yield curve inversion for more than a year now.

Leaving aside the yield curve inversion as a predictor of recession, let’s look at the inevitability of it in the first place. The fiscal boost from tax stimulus is set to fade and even the gradual monetary tightening from Fed so far will show up in rate-sensitive sectors of the economy soon.

Germany is showing broad-based signs of slowdown. China is in the middle of a slowdown – growing at the slowest pace since 1990 - with or without the trade war being made further acute by the tariffs. Australia and NZ are moving to a lower growth trajectory too. While the US economy is relatively on a strong footing at the moment, and that will keep the Fed from turning decisively dovish yet, the trade war risks will keep them on their toes.

It is not entirely unreasonable to argue that this time is different from the perspective of yield curve inversion not leading to a recession for it is merely a technical definition. But it is dangerous to ignore the clear warnings signs from the yield curve inversion of the inevitable economic slowdown particularly in US over the next two years.

US Treasury yield spread-SPX-US GDP growth rates

Source: Bloomberg

The chart above shows the relative moves of the 10-yr –2yr spread against the US economy (GDP growth rates) and US equity markets (SPX). The circles marked are the past occasions when the yield curve inverted.

Some inferences from the chart:

  • While it is easy to spot the follow up economic recession since the yield curve inversion in the past recessions of 1981, 1991, 2000 and 2008, what is more striking from the chart is the amount of time lag between the inversion and the eventual recession.
  • Take the case of 2008 crisis, the yield curve first inverted in December 2005 and kept getting more acute through the next 12 months and the recession came out only a couple of years later. The earlier instances are not different either.
  • The equity market’s reaction has not been consistent though. In 2008 the fall came a couple of years after the first instance of inversion, whereas in 2000 there wasn’t much of a lag. And in 1981 and 1991, the equity sell-off wasn’t anywhere near as dramatic as the 2000 and 2008 instances were.
  • In essence, the timeline for the cause and effect of yield curve inversion vs economic recession/slowdown is rather long. So, this click a minute headline grabbing news on yield curve inversion is irrelevant for most long-term investors and dangerous to ride on for short-term traders.
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