Hanging on - recession signals

In Focus – Recession already? What to make of the yield curve inversion.

What happened?

This week, one of the world’s most dependable augurs of economic doom briefly flashed red. The difference between the yield available from lending to the US government in the short term versus a longer term loan turned negative (though at the time of writing is marginally positive). Since 1950, a so-called yield curve inversion has preceded every US recession, with only one false positive (in 1967 when the inversion was followed by a slowdown, but not recession). Where the US economy goes, most of the rest of us will follow. We explore some of the causes of this inversion, its track record as a signal, as well as some tips for investors.

The intuition

The intuition behind the yield curve’s predictive power is relatively sound. A large part of the path of expected government borrowing costs over time (the yield curve) reflects some averaged assumptions about how short term interest rates will evolve into the future. Traditionally, in order to incentivise me (the lender) to provide my precious savings to the government for longer term loans, rather than a series of shorter term increments, there is also a bit of extra juice – a term premium. This term premium waxes and wanes over time, but is generally seen loosely as compensation for the risks of tying up those hard earned savings for longer periods of time. It is also unobservable, which complicates matters a little of course.

Anyway, in this context, an inverting yield curve – often focused on the difference between the 2-year and the 10-year yield, but 3-month yield can also be used at short end – is often interpreted as investors suggesting that the longer term growth prospects are weakening and near term monetary policy is about to become, or is already, too restrictive. Recession nears. A vital point to nonetheless keep in mind is that the yield curve inversion does not necessarily in and of itself cause recessions. For example, the yield curve inversion that occurred in August 2019 clearly did not cause a global pandemic in March 2020. Yet this occurrence will (wrongly) contribute to its ‘statistical significance’ in forecasting recessions. It also exemplifies the dangers of blind statistical analysis without a logical intuition or explanation. The slope of the yield curve is perhaps best seen as a useful summary statistic – not a silver bullet.

The evidence

As noted above, this statistical soothsayer’s CV is relatively strong. There are some important caveats nonetheless. A National Bureau of Economic Research paper from 2010 investigated the yield curve’s predictive power more broadly,[1] looking at its ability to speak of incoming industrial production and wider growth indicators. The paper demonstrated that when viewed over longer periods of time and across countries, the yield curve was only really informative in certain countries (the US and UK among them) and seemed to be weakening as a signal over time. One question raised by the paper centred on the yield curve’s foggier message on Japan’s outlook over the period of basement level interest rates. The implication being that the yield curve’s potency as a seer suffers as interest rates approach the zero lower bound, as has been the case for much of the developed world in the last few decades.

Can I use the yield curve to time markets?

In a word, no. The problems here are several.

First and perhaps foremost, like all best fairground soothsayers, the inverting yield curve prefers to keep its predictions pretty vague. Recessions have followed yield curve inversions with a range of 9 to 34 months in that period since 1965 and there is no corresponding relationship between the size of the inversion and the recession that follows. Recessions are as much part of economic life as rain is to the British summer. Few would gasp in astonishment if I, eyes closed in solemn concentration, predicted that there would be several weeks of this summer blighted by dismal weather.

Furthermore, the performance of the equity market in the period after a yield curve inversion does not suggest disinvestment or de-risking as a profitable strategy. This is consistent with a recent paper from AQR[2] who showed that although the slope of the yield curve can be somewhat predictive of near-term economic growth, that’s a far cry from profiting from such information. Many of the worst (not all) recessions are a response to build ups of giant excess and distortion. Recessions are often a purgatory force to bring the economy back into some form of harmonious equilibrium. To that end, looking around the world today, there appears to be no urgent need for a recession, particularly in the US where households and businesses look in good shape in aggregate.?Labour markets are also recovering exceptionally briskly, and US High Yield bond spreads – a perceived measure of credit worthiness for lending to a subset of riskiest companies – have retraced down to near historical lows. This data is not consistent with an imminent recession, though of course a lot can change in a short space of time (as recent years have shown us).?

The intuition that the inverting yield curve is warning of the dangers of overly restrictive monetary policy, jars in this instance with the fact that real interest rates are still in deeply negative territory in the US and elsewhere too.

Conclusion

As noted above, the yield curve should be seen as a useful summary statistic rather than an automatic trigger to act. The prediction is necessarily vague and the context for each inversion needs to be unpacked carefully. We can say that we are at a fairly rare point (certainly in the last few decades) in terms of the outlook for monetary policy around the world. Market pricing assumes that central bankers in much of the developed world move interest rates very aggressively higher in the next year, but are then forced to cut back those same interest rates on a 3 to 5-year view. This is what it will apparently take to tame the inflationary forces we are all wrestling with at this epochal moment.

It doesn’t take that much imagination to see alternate futures for the path of inflation, interest rates and growth. From changes in the technological context to the more imminent lapping of giant rises in prices, there are still plenty of disinflationary forces to consider in the path ahead.

Longer term investors can relax and ignore all of this in truth. None of it matters. Your eyeline should be kept well above the next recession and focussed on the longer term prospects for productivity growth, which remain well founded on our uniquely frustrating yet talented species.

[1] https://www.nber.org/system/files/working_papers/w16398/w16398.pdf

[2] Inversion Anxiety: Yield Curves, Economic Growth, and Asset Prices – AQR (2019)

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