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The US yield curve inversion – an indicator of recession or not?

The US yield curve inversion – an indicator of recession or not? In a word, not. There are clearly issues in the world. A recession may hit the global economy more quickly than some expect. Nonetheless, the long-lived influence of global central bank policies on bond yields diminishes the signal of the yield curve today relative to history.

The US yield curve has a decent track record of foreshadowing recessions through history, as illustrated by the chart below:

Treasury spread 10 yr yield

Source: St. Louis Fed

Does this indicate the recent yield curve inversion means another recession is on the way? Maybe. There are many risks to the global backdrop. But it is worth listening to Janet Yellen, Chair of the US Federal Reserve, talking about the yield curve inversion on August 14:

“Historically, it has been a pretty good signal of recession, and I think that’s when markets pay attention to it, but I would really urge that on this occasion it may be a less good signal. The reason for that is there are a number of factors other than market expectations about the future path of interest rates that are pushing down long-term yields.”

Probably the main factor Yellen was referring to is central banks (notably in the US, EU, Japan and the UK) spending much time post the 2008-9 recession buying government bonds. The aim of these so called “Quantitative Easing” policies was to further loosen monetary policy once the cash rate was effectively reduced to zero. Central banks announced ahead of time the amount of government bond purchases and the timeframe, and at the time of the announcement (if not before) the market reflected these expected purchases via higher bond prices.

This so-called ‘stock effect’ is important. By reacting more when (or before) purchases were announced, and less when they took place, market prices largely adjusted to purchases ahead of central banks entering the market to transact. Importantly, this implies that the impact of central bank purchases on bond prices should also not be reversed until central bank balance sheets are expected by the market to revert to a smaller, pre-crisis size. There are no indications this will happen (in fact quite the opposite), so quantitative easing has led bond yields to be sustainably lower today than would be the case if such policies had not been used.

We can estimate the impact these policies have had. The US Federal Reserve regularly updates a model of two components of bond yields:

  1. The so called ‘risk neutral’ rate shows how the evolution of conventional monetary policy is likely to impact the yield curve in isolation;
  2. The term premium = The bond yield minus the risk neutral rate. This illustrates more clearly the impact of unconventional policies such as Quantitative Easing.

Whilst such a decomposition is not 100% accurate in isolating the impact of unconventional policy (other factors are involved as well), the long-lived large impact of Quantitative Easing in the US and elsewhere is still clearly apparent:

ACM 10 yr term premium

Source: US Federal Reserve, Daintree Capital

So, it is important to compare like with like. The yield curve is not sending the same signals today as it has in the past. Therefore, angst around the potential for US recession in the next year or two may be misplaced, at least as far as yield curve indicators are concerned. Whilst a recession may indeed hit the global economy more quickly than some expect, the yield curve is just one of many warning signs that markets are faced with at the moment. Given the changed nature of the signal it is sending, we would not put too much weight on the yield curve inversion in isolation when determining the expected future path of markets.

 

The author, Justin Tyler, is a Director at Daintree Capital. Click on the links find out more about Daintree Capital’s Core Income fund and High Income fund.

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