The yield curve is not an end-all-be-all indicator, and slowing growth does not equal a recession.

Our Top Market Takeaways for the week ending August 16, 2019.

Digging deep

Highway to the danger zone?

It’s here. It happened. A popular measure of the U.S. yield curve inverted for the first time since 2007 (the U.S. 2-year–10-year Treasury curve, to be specific). News headlines were quick to ring the recession bell, citing a well-known axiom that yield curve inversions tend to precede recessions. Given that recessions are usually accompanied by bear markets (or at least a market decline), many investors feared we may be on the “highway to the danger zone.” Stocks around the world sank, and roughly half of global equity markets (as defined by the MSCI All-Country World Index) have now declined -20% or more from their recent highs. Deep breaths. Below, we unpack what yield curve inversion means and why, even amid this development, we still don’t think a recession is imminent.

First, what does “inversion” mean? When the economy is healthy, bond buyers demand to be paid more interest on long-term bonds than they do on short-term bonds. That’s because there’s usually more opportunity cost (and interest rate risk) associated with locking up money for a longer period of time—investors need to be compensated for that. The yield curve is said to be inverted when the interest paid on short-term bonds (here, the 2-year Treasury yield) is greater than the interest paid on long-term bonds (the 10-year Treasury yield). But, why would investors accept less interest to lock up their money for longer? It’s usually because investors are so nervous about economic stability in the near term that they’re willing to take lower interest rate payments for longer-term safety.

Why did the yield curve invert on Wednesday? This didn’t come out of nowhere. The yield curve has been flattening (that is, the difference between long-term rates and short-term rates has been getting smaller) over the past year as investors grapple with slower global growth, muted inflation, trade wars and various geopolitical dynamics. In response to such headwinds, central banks around the world have recently started easing policy or are expected to do so by year-end. In sum, global yields are falling in part because growth stinks, and central banks have started to lower interest rates to try to spark more economic activity.

Weak economic activity data out of China and Germany on Wednesday added to growth fears, sending more investors scurrying to the shelter of safe, long-term U.S. Treasuries. The demand dragged down yields on the 10-year part of the curve faster than the 2-year part of the curve, and POW! Inversion. 

Line chart showing the U.S. Treasury spread from 1985 to 2019. The chart highlights the spread between the 10-year and 2-year parts of the curve; when the yields on the 10-year are dragged down faster than the 2-year, then line displays curve inversions. These inversions are displayed four times in this timeframe.

Earlier, we mentioned that yield curve inversions tend to precede recessions—is this time different? We think it might be. Usually when the yield curve inverts, it’s a symptom of the Fed tightening policy and going too far (it raises short-term rates too high, and the cost to borrow starts to creep above potential returns on investment). This chokes off growth, creates fear and suppresses long-term rates to the point where short-term rates eventually exceed them. This time around, the Fed has had its eye on slowing global growth and is already cutting short-term rates to help keep the U.S. economy humming along. Meanwhile, many foreign investors have “lost that lovin’ feeling” for relatively low (and, in some cases, negative) yielding bonds in their own countries, so they’re flocking to U.S. bonds to try to lock in positive rates of income. In this vein, it’s not that the Fed has raised short-term rates too high, but rather that long-term rates are reacting to the slower global growth environment.

Here, we’d also note that the yield curve is not an end-all-be-all indicator, and that slowing growth does not equal a recession. We watch many indicators to develop our outlook and recession odds, and a number of them are still holding up well (e.g., U.S. retail sales data released this week showed that consumer activity remains strong; U.S. corporations don’t seem stretched; the labor market is still robust, etc.). Bottom line: Yield curve inversion is a warning sign of mounting risks, but it doesn’t change our late-cycle macroeconomic outlook at this time. We still think that growth is decelerating to around its trend level, that issues like trade wars will continue to be a headwind, and that volatility is here to stay. But our base case does not call for a recession on the near-term horizon.         

But markets freaked out, didn’t they? Yes, they did. But, here’s the thing: While recessions do tend to follow inversions, the lag between inversion and recession varies quite a bit. Since 1967, the time between inversion and recession has ranged from 9 to 26 months. Not super helpful if we’re going for predictive precision. Recessions aside, it’s also hard to pinpoint when equity markets will actually peak. Again, history shows us that an inversion precedes a market peak, but the time between the two has been anywhere from 2 to 19 months! Lastly, the yield curve didn’t stay inverted for long this time around—by midday Wednesday, the yield on the 10-year had moved back higher than the 2-year. Such a brief inversion may have been an anomaly. We’ll be watching to see if it happens again and sticks.

Is it worth staying in the market, given the uncertainty? Is the sky blue? Do fish swim? All year long, we’ve been talking about things like harvesting yield, rotating exposures into higher-quality assets, and seeking out investments with all-weather growth trends to help insulate investment portfolios against volatility. We’ve been bracing for this. While weeks like these can be unnerving, history shows us that volatility is normal, and it’s important to keep your long-term goals and investment plan in mind—and sometimes doing nothing is the best thing to do

In case you missed it

5 things on the trade war

Earlier this week, we held a global call on the big questions facing investors on trade: Does the U.S. Administration want a deal before the election, or is “tough on China” the better political path? Will further escalation spell doom for the cycle? Is the Fed’s decision to cut interest rates enough to offset the uncertainty in markets? You can find all the details here.

All market and economic data as of August 2019 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.


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