The flattening of the yield curve points to a classic recession warning signal for the market. However, on its own, it merely warns us to expect a recession sometime in 2019 to 2024. The signal still provides useful information about where we are in the economic and market cycle and hence a guide to which assets and sectors have had historically the best prospects. So here's a quick summary about why it's true, why it's useless to time a recession and what it does tell us about the economic and market cycle.
What is a flattening and inversion of the yield curve?
A flattening yield curve is when the difference between (short term cash) interest rates and the long term interest rate yield from investing in bonds narrows. Interest rates represent the demand for loans and/or the central bank's desire to balance the economy to maintain growth and hold down inflation.
As the two rates converge and the yield curve flattens it says that investors are expecting a peak in interest rates. Finally when the yield curve inverts, current interest rates are higher than future interest rates, the implicit assumption is that interest rates are now so high that growth and inflation is likely to slow in the future and interest rates will therefore fall.
Does a yield curve inversion signal recession?
The answer is yes, it is a very good signal that recession is coming. The specific signal for the inversion of the yield curve is the comparison of yields from the two-year US treasury bond and the ten-year US Treasury bond. The two-year bond yield has risen above the yield on the ten-year ahead of all five recessions in the last forty years.
Why are the yields on the two-year and ten-year Treasuries chosen?
These are two historically well traded and recorded benchmarks for the Treasury market. The yield on the ten-year bond represents a good estimate of the long-term expectation of the interest rate trend. Two years is probably the longest horizon for attempts at economic forecasting, so the two-year bond yield reflects the current consensus on the direction of short-term interest rates. That means it gives the signal earlier than waiting for interest rates to rise above the ten-year bond yield. Liquid benchmarks and familiarity amongst investors makes these bonds a strong indicator of investor expectations, less likely to be distorted by other factors.
So when is a recession due?
Unfortunately, while the yield curve inversion has been historically accurate at predicting a recession, it is a poor timing signal. Recent history, the last forty years in the US, has seen a lag between signal and recession of one year to three years. Additionally we are not at inversion, the yield on the ten-year is 2.9% and the two-year has risen, even more sharply to 2.5%. That flattening to less than a 0.5% difference has historically led to an inversion, but again with a lag, of between a month and four years! Added together and we're left forecasting a recession in one to six years.
Given that there have been five recessions in the past forty years and the last over a decade ago, it doesn't seem particularly useful to know that there will be a recession at some stage over the next several years. Historically, waiting for the yield curve to invert has given more than sufficient warning of a recession.
So what does the flattening of the yield curve tell us now?
It is a signal that we have moved to a later stage of the economic and market cycle. Historically that has been a period when higher growth and inflation has favoured investment in assets like property and commodities, while the defensive sectors of the equity market have underperformed, such as so pharmaceuticals, consumer staples and utilities. When the yield curve does finally invert we should finally start taking warnings of recession more seriously.
And what about the 10-year Treasury bond yield hitting 3%?
That's a negative for markets, but a positive for the economy. By discounting higher interest rates ahead investors are implicitly expressing optimism about growth and inflation, as opposed to fearing low growth and deflation. Indeed as the 10-year yields rise it postpones the flattening and inversion of the yield curve discussed above. But while that's positive for growth, it is not positive for markets. Higher interest rates put pressure on investment valuations that have been based on the expectation that interest rates will remain low and forced investors to bid up prices for assets offering income.
This conflict between improved growth prospects and a need for a reassessment of valuations points to a more volatile investment market ahead.
But we are already at historically high valuations for at least the US equity market, while interest rates and bond yields are rising from very low levels. These factors suggest that further increases in equity markets may be more modest than in the past and are likely to be more volatile as investor sentiment swings between cyclical and valuation factors.