The flattening-out of the US treasury yield curve is not at this stage recession-inducing, but could lead to a “self-fuelling bear market” if it takes hold of investor sentiment.
Last week’s inversion of the three-year and five-year treasury yield curves added fuel to the fire for markets that were already jittery from unanswered questions about president Trump and Xi Jingping’s tête-à-tête at the G20 summit.
Axa IM fixed income CIO Chris Iggo said the coverage of the inversion via all the usual “hysteria channels” arguably led to the “violent sell-off in bank stocks” that took the S&P 500 down over 3% last Tuesday, resulting in one of its worst intra-day sell-offs of the last five years.
In his eponymous weekly blog, Iggo’s Insight, he said the hysteric coverage of the yield curve inversion could “drive a self-fuelling bear market”.
Red flags were first raised in September when the spread between the two and 10-year treasury yields narrowed to 0.2%, its lowest level since August 2007.
In the months since, the yields on the two US government coupons have moved closer together with just 0.09% separating them.
“So, the sequencing for the bear is, yield curve inverts, stocks tumble, confidence falls, real economic decision-making becomes more cautious, the data weakens as a result and stocks fall further, causing interest rate expectations to decline and the yield curve to invert more,” said Iggo.
Self-fulfilling prophecy
Rathbones head of fixed income Bryn Jones agreed that an inverted curve “puts a bit of a squeeze on the banks”, which trickles down to the consumer.
“If [the banks] haven’t got a steep enough curve and net interest margins are affected, then the banks might start to think ‘maybe I won’t lend so much money as aggressively as I have done before’.
“The knock-on effect is that lending drops and then spending drops, and consumer weakness becomes a self-fulfilling prophecy.”
No recession tomorrow
But Jones said an inversion toward the front end of the curve in and of itself does not mean a recession tomorrow.
He notes that in 2005 it took 28 months from the inversion of the three-year and five-year curves before the economy was in recession.
“Curves can invert and remain inverted for a while,” he explained. “It’s only when the ultra-long end inverts over the very short end when you get a truly inverted curve that is a clear signal you should start to worry about a potential recessionary impact.”
He added that bull markets in risk assets and equities throughout history have still occurred when curves are flat.
“The five-year to 10-year is pretty flat but you’re still getting one of the longest bull markets in equities history.”
Market says Fed is done
Iggo said the current flattening of the yield curve gels with his own views of a weaker economy starting in the second half of 2019 and going into the US presidential election year of 2020.
Though he admits we could be at the start of the process where the Fed eases up on its aggressive rate-raising path, this would not see the US heading into a recession for the next 12 to 18 months.
Meanwhile “the market is now saying that in December the Fed is done,” he said. “I don’t agree with that conclusion.”
Trapped bulls
Brooks Macdonald co-founder and Defensive Capital Fund manager, Jon Gumpel, said the US treasury yield curve inversion is a signal that the US economy is unable to cope with higher rates. Meanwhile global growth is slowing.
“No country is an island to misquote John Donne. I don’t think the US can do it all by itself which is a shame because we hoped the US could pull the world out, but it can’t.”
In any case he added: “We are probably due a recession.”
“It’s only because people get so committed to their bullish positions that it has to be such an awful thing. To my mind all the fuss about it is that there are a lot of trapped bulls out there.”
