Originally posted at ExecSpec.net
Normal economic expansions are supported by positive sloping yield curves where riskier long-duration maturities offer higher rates of return than lower risk short-duration debt. Investor aversion to an inverted yield curve, where short-term rates are higher than long-term, is tethered to an assumption of credit tightening that is pricing in risk of an economic slowdown.
Long before any portion of the positive-sloping U.S. yield curve inverted in 2019, legions of doom have salivated for this moment as a harbinger of the end of times to this 10-year-old bull market in stocks. While the more popular 10-year minus 2-year Treasury yield spread has yet to invert, many latched onto the minor inversion on March 22 of the 10-year minus 3-month Treasury spread as a signal to start the countdown clock for the next recession. The prescient aspect to yield curve inversions is they have preceded each of the past five recessions by six months to two years. This can be important for investors seeking an early warning system to exit the stock market well before a GDP contraction generates negative investment returns. Before we get too worked up over this development, it should be noted that there can be a very long lead time before trouble sets in. Additionally, virtually all key short-term to long-term yield spreads invert prior to economic trouble, which has yet to occur.
The last time we moved from a positive yield curve during an economic expansion to an inversion was January 2006. It presaged a stock market peak and future economic contraction but was off by almost two years. Significant investment returns would have been missed for those anxious to sell the curve. The slight inversion today in one of the yield spreads is not a sign to run for the exits given the historical upside in stocks and the economy at past inflection points.
Waiting on the entire yield curve to invert may be helpful, but it’s far more precise to wait for other types of risk spreads to pop. Various high yield option spreads and the TED spread of three month treasuries minus three month LIBOR can guide us better to the timing of future trouble. Currently these risk spreads remain very low, signaling that our flattening yield curve is not pricing in recession expectations this year. It’s likely when the final stock market peak arrives and begins to capitulate, we will see these risk measures surging higher in sync.
Two major factors flattening our yield curve are the Fed’s overshoot in boosting the short-term Federal Funds rate and the negative yields in Europe sending euro investors to the U.S. bond market suppressing our longer maturity yields. The Fed’s eagerness to raise rates in late 2018 and announcing many more hikes for 2019 was naive in ignoring the clear escalation of a global slowdown that was beginning to impede U.S. growth and inflation. We would prefer the Fed avoid a yield curve inversion they helped create by cutting their Fed Funds rate until economic momentum turns up and a China trade deal is complete. Below we can see the poor timing of the Feds recent rate hikes that coincided with a severe slowdown in Purchasing Manager Indices (PMI) throughout Europe. With major countries such as Italy and Germany in contraction mode and trillions of negative yielding bonds, it’s understandable that investors prefer our 10 year Treasury at 2.4 percent than a German 10 year bund at 0 percent.
We feel the odds of a recession are quite low in 2019 and 2020 with the overwhelming swing factor of a China trade deal or a no-deal tariff escalation arbitrating the outcome. In the unlikely event that China and U.S. talks fall apart with a new round of tariff hikes, then recession odds would jump. Our forecast is for a slow path of negotiations reaching a conclusion in the second quarter. The world economy will stay in slow growth mode and the hype of an inverted yield curve will remain until there is a U.S and China trade deal and a new growth cycle anticipated.
