Determining whether an inverted yield curve signals a US or global recession continues to focus the minds of investors in 2019. Mark Robertson explains why our actions will matter more in determining whether a recession is on the horizon than what can be a misleading indicator.
For the first time since 2007, the two-year/ten-year Treasury yield spread turned negative on August 14, once again reviving fears of a recession. Given that previous yield curve inversions have preceded each of the past five recessions since the early 1980s, these concerns are understandable.
Figure 1: US yield curve inversion: 2-year/10-year Treasury
Source: Macrobond
The recent inversion, alongside a new record low 30-year bond yield, have followed the intense bull-flattening trade seen since the end of July. These, in turn, have been driven by fears around escalating trade war risks and a weaker global growth outlook. The market is pricing in lower odds that this is a mid-cycle downturn and higher odds it could be the beginning of a recession.
Predictive signals have always held a seductive allure in financial markets. However, while an inverted US yield curve undoubtedly conveys a feeling of unease among investors, it should be remembered recessions are not that common. This means it is statistically impossible for any single recession indicator to be robust. Worse still, the unprecedented quantitative easing (QE) interventions of the last decade may have impaired the yield curve’s signaling capacity. After all, flatter yield curves are a natural consequence of developed market central banks’ use of QE to intentionally lower long-term yields in an effort to foster investment and consumption.
History also reminds us the threat is not necessarily imminent. Empirical research from Oxford Economics, a consultancy, shows that over the past five recessions the lead time between inversion and the onset of recession has averaged approximately 21.5 months. Indeed, the range of the lead time is quite wide, spanning from 10.5 months ahead of the 1981-1982 recession to 36 months ahead of the 2001 recession.1
Reference
- Oxford Economics – Research Briefing | US: “Despite curve inversion, don’t write off the economy yet”. John Canavan 14thAugust 2019
