Last week, market interest rates dropped and hit the panic button. The three-month to 10-year (3m10y) portion of the U.S. treasury curve inverted for the first time since 2007. History tells us to respect the inversion so it’s understandable that investors are spooked—every U.S. recession in recent decades has been preceded by an inversion of the 3m10y yield curve. Yet, it’s also true that not every inversion has been followed by a recession. Is this inversion a false positive?
It’s too early to tell. Typically, an inversion would need to continue for at least a few months before investors worry. Given how over-emotional the market currently is, we need more than just a few trading sessions to see if this is the real deal.
Inversion needs to be broader too. So far, it only extends to the three-year point. The 3y5y curve is flat, while the 5y30y curve has actually widened to its steepest level since 2017. Ahead of previous recessions, inversion was seen across the whole yield curve.
It also needs to be deeper. A legacy from quantitative easing is that central banks still own huge quantities of government bonds, repressing long-term yields. As such, it’s easier to invert the curve, fading the recessionary signal somewhat.
And even if you want to throw all this caution to the wind, the lead times between inversion and recession have tended to be long and variable, sometimes extending to three years!
More important than historical comparisons, is understanding why the curve inverted. The immediate trigger was the U.S. Federal Reserve (Fed)’s signal last week that it’s close to being finished with its hiking cycle. Markets duly priced in Fed policy rates remaining unchanged for an extended period: flat rate expectations imply a flat yield curve. Weaker-than-expected U.S. and Eurozone PMI data then prompted investors to shed risky assets and purchase safer assets, such as U.S. treasuries, causing the curve to invert. Market rates now look as if they are pricing in Fed cuts by the end of 2019. The inverted yield curve isn’t necessarily signaling a recession, but rather reflecting exaggerated investor anxieties about future economic trouble.
Given that a slowdown is underway, investor concerns are justified. But a U.S. recession remains unlikely. Just look at the labor market—it’s never been so strong a year before recession. The drop in mortgage interest rates will also be a strong tailwind for the economy, while credit—typically the canary in the coal mine—continues to trade at relatively tight spreads.
Admittedly, the global outlook has been more perturbing. Europe is weakening, Brexit negotiations still have their finger hovering over the panic button, and U.S./China trade progress is painfully slow. Yet, the Chinese economy should bottom-out soon, putting a floor under the European growth disappointments and eventually lifting global growth.
(I admit though, that relying on Chinese stimulus to stop the global slowdown in its tracks is a precarious assumption. Perhaps that’s why central banks and markets are quite so cautious?)
From an investor perspective, whether or not the yield curve inversion is a false positive, there are important sectoral realignments to consider. Financials don’t outperform when yield curves are flat, let alone inverted. And, more generally, in a slowdown, defensives tend to outperform cyclicals. Respect this signal.
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