When the 10-year Treasury yield declined below the 3-month yield earlier this summer, investors started to fret about the implications of an inverted yield curve. Inverted yield curves happen when short-term interest rates are above long-term rates. For investors, they have historically been a reliable indicator of recessions, predicting 7 of the past 8 recessions (table 1).
Inversions tend to cause recessions because they make bank lending less profitable (therefore less willing to lend) and make economic agents more nervous about the future path of growth (therefore less willing to borrow and spend). Less lending, less borrowing and less spending, when sustained, lead to recessions.
Importantly, the inversion of the 3-month/10-year curve earlier this summer wasn’t confirmed by other maturities. Although noticed by investors, it didn’t have much of an impact on market sentiment. That however changed on Wednesday as we briefly saw the 2 year/10year curve invert in the morning of trading. Equity markets sold off immediately.
Time to panic?
Not quite. This time may be different.
To start with, yield curve inversions have historically been caused by monetary policy mistakes. By raising short-term rates too much for too long, even after the curve inversions occurred, the Federal Reserve has historically been the main cause of inversions. We are not currently seeing any of the tell-tale signs that the Federal Reserve has gone too far this cycle, making a policy mistake. In fact, this time around the Fed is actually easing into the inversions with the first rate cut in over 10 years delivered just this past July. In brief, the Fed is not in a tightening mode. It has started to ease and indicated it is ready to ease more as needed. Over time, this could help short-term interest rates move lower.
Secondly, the recent inversions have largely been self-inflicted and at times self-fulfilling. The ongoing uncertainty related to the trade dispute with China has led to a “flight-to-safety” and the collapse of the 10-year Treasury yield in recent months. As short and longer-term yields converged, fears of curve inversion added an additional round of “flight-to-safety” bond buying, which further suppressed longer-term yields. A resolution to the trade dispute (something we believe the Trump administration can control) would likely push long-term interest rates higher.
Finally, yield curve inversions tell us little about the timing of future downturns as the period from inversion to the start of the recession has varied from 5 months to 17 months with stocks having historically (and interestingly) performed well in the 12 months following yield curve inversions.
In brief, we are not ignoring the recent inversion of the yield curve but we are not yet ready to make a recession call. The inversions of portions of the Treasury yield curve are important signals but would need to be sustained to become problematic. Furthermore, both Jerome Powell (Fed’s Chairman) and Donald Trump can quickly reverse the negative economic message currently being delivered by the bond market with their actions. In due course, we believe they will do just that.
As always, we will continue to monitor the situation closely and are prepared to make other adjustments to portfolios if deemed necessary.
Thank you for your continued trust and confidence you have in us.