Today marked the arrival of a long expected event, namely the inversion of the US yield curve between two and 10 years. This is an important event as historically it has been a very reliable indicator of impending recession. History tells us that once the 2s-10s curve inverts, on average a recession is a year to 18 months away.
So we thought it might be useful to examine why the yield curve has finally inverted and what the chances of a recession actually are.
Starting with the easy part, why?
First let’s look at macro-economic data across the world. Very simply we have been experiencing a globally coordinated economic slowdown. It is true that economies in some parts of the world such as the US and China are still in reasonable shape, but they have been slowing down nevertheless. In the UK the economy is severely stuttering and has little room on the downside to avoid tipping into negative growth. In Europe, the largest three economies (Germany, France and Italy) have seen marked slowdowns and like the UK have little downside protection.
This slowdown though is becoming quite protracted and the longer it has gone on, the more worried investors have become. A consequence of this is that fixed income investors will increase the exposure to pure ‘risk-free’ assets such as US Treasuries, Bunds or Gilts, but to protect portfolios they need to hold more duration than normal, which is one major driver of yield curve shape. As a result rates curves become lower as well as flatter, which is perhaps more sinister than higher yields and flatter.
We also need to consider Q4 2018 in our market assessment, as this was a brief dry run of what a recessionary environment might look like, and it was ugly. Once again this encouraged investors to hold more ‘risk-free’ assets, and for them to neutralise risk positions these risk free holdings needed to be further along the yield curve, again encouraging rates lower and yield curves flatter. This has been a theme throughout 2019 so far.
Soft landings have successfully been engineered in the past with a combination of monetary easing and fiscal expansion, and perhaps in the absence of extraordinary factors, the recent change of tone by global central banks towards easing might have been enough to encourage the cycle to continue.
However, we do not have an absence of external factors, quite the contrary in fact. Brexit is almost upon us and the chances of a hard Brexit have been increasing – we don’t need to look further than the continuous erosion in the value of sterling to be sure of this. A hard Brexit would almost certainly tip both the UK and Europe into recession. So today’s inversion of the UK curve is only surprising in that it has taken so long. Then we have the seemingly ever more entrenched trade war between the US and China, which if not resolved could have some very severe consequences for both nations, their businesses and their consumers. Do we really think that Apple wanted to move 30% of its production away from China? This is clearly a huge issue and not without risk to supply chains. Do we really think workers in Huawei in the US are rushing out to buy new cars this weekend? Of course not. The trade war is firmly in the minds of both consumers and businesses and the longer it continues, the worse it will be.
Then in the last week we have two new sets of geopolitical concerns, and while both are not of the magnitude of Brexit and trade wars, they may have been the straws that broke the camel’s back from a yield curve perspective. The first is Italy and the prospect of fresh elections, and the second is the prospect for a market unfriendly election result in Argentina with the spectre of a fresh default.
All of these concerns drive the need to hold more ‘risk-free’ assets with some duration to protect portfolios, as outlined above, driving yields lower and curves flatter and ultimately to inversion. The reason for inversion is clear, macro-focused investors have become increasingly worried about the prospect of recession. However, now that we have inverted curves does this make recession more likely?
The answer is unfortunately yes. Many investors are not macro investors and will be looking for signs (such as the shape of the yield curve) that all is not well, and will adjust their risk profiles accordingly. Perhaps more importantly than this, the providers of credit and lending facilities also consider yield curve shape as part of their lending assessment. The result of both of these is a tightening of financial conditions which if left long enough, has historically been the single biggest driver of recessions.
Now before we get too carried away with the yield curve and its magical predictive qualities, we have learned that this cycle is different and that we must challenge conventional wisdom. So here is a glimmer of hope. Historically the banks have held significantly less capital and have very quickly turned the lending taps off as the economic environment has changed. Nowadays their capital bases and risk procedures are far more suited to lending through the cycle, which is what regulators want them to do. So maybe they will not be as trigger happy as they have been in past. But can leopards change their spots? Unfortunately, the answer is probably not.
The yield curve inversion is totally justified in our opinion given the weight of geopolitical events, and one thing absolutely for sure is that an inverted curve is not good news. The only question is how bad this news is, and how it might transmit and foster further economic concern.