How Big A Deal Is The Yield Curve?

    Michael Greenberg, CFA, CAIA

    Profile name

    The yield curve has been a hot topic lately, since the 2s10s curve inverted briefly, some have suggested a recession is all but guaranteed to follow. Historically it has been a harbinger of recessions so it’s no wonder this inversion has gotten so much attention. However, it’s important to take a more detailed look at what the yield curve does and does not tell us before declaring it the canary in the coal mine.

    Should investors be worried?

    Yield curve aside, worrying about an impending recession can become a self-fulfilling prophecy. The feedback loop looks roughly like this: investors read doom and gloom headlines, their negative sentiment influences their behaviour, which leads to weaker economic data which leads to a recession. Instead of being emotional about markets, lets look at the facts.

    Historically an inverted yield curve has been a good predictor that a recession is coming but it doesn’t tell us much about when. For example, in the period when we last saw a yield curve invert, it was nearly two years later before the economy was in a recession. During that time the market experienced a great rally. The table below highlights this point well.

    This shows why investors shouldn’t look at the yield curve in isolation. As portfolio managers we aren’t trying to time the markets, but we do watch indictors that can help us gauge market health. Some macro indicators like widening corporate spreads, weak capital expenditures and a falling Leading Economic Index appear to be reinforcing the story of a slowdown. Likewise, on the micro side we are seeing decelerating earnings growth and downward earning revisions, but valuations have not softened to any great extent. That’s why we have been more cautious with our portfolios and gradually reducing exposure to equities and corporate credit.

    What can we learn?

    Let’s look more specifically of what the shape of the yield curve can tell about markets and monetary policy. The curve has seen a bull flattening/inversion as rates at the back end of the curve have declined more than at the front end of the curve. This suggests that the recent smaller-than-expected rate cuts by the Federal Reserve are perceived by the market as a policy mistake. Market expectations of weaker future growth and lower inflation mean that the Fed should potentially have been more aggressive in its policy response at the last FMOC meeting and the central bank now appears to be behind the curve in the market’s view.

    Given that rates are close to the hypothetical zero bound, the Fed doesn’t have as many bullets left in the chamber as it had going into other slowdowns, so they need to maximize their effect. The market is still pushing the FED for more cuts, with expectations of approximately 100bps of rate cuts over the next 12 months. This puts the puts FED in a corner somewhat. If they are not dovish enough, this could lead to a deeper inversion of the curve and could put investors into risk-off mode. On the other hand, if the Fed overextends itself there are other risks too and optically it may look like they are caving to pressure from President Trump and thus risking their independence.

    The road ahead

    The market is already pricing in significant rate cuts and it will be difficult for the Fed to be more dovish than that unless data really disappoints, or the trade tensions spin out of control. In previous press conferences Powell has said ‘an ounce of prevention worth pound of cure’ but he may have missed the chance to offer ‘the prevention’ during the last meeting with the 25bps cuts and weak forward guidance. We will see what they can muster at the next FOMC meeting.

    To avoid a recession, central banks will either need to get more aggressive with policy or something else must spark expectations for future growth and inflation to steepen the yield curve. This could be more fiscal stimulus in the form of additional US tax cuts or maybe a new stimulus policy from Germany. We would not hold our breath and things probably need to get worse first before they turn to that option. On the other hand, it is difficult to see monetary policy meaningfully lifting longer-term growth and inflation expectations given trade sentiment is not improving, and if anything continues to worsen. This leaves us a little more concerned about the downside risks to growth as the policy response in the US may fall short of market expectations.

    We remain comfortable with a continued moderate risk off positioning in our portfolios with an underweight to equity and overweight to fixed income. We are not in the recession camp yet so by no means would we head for the hills, but the environment is getting trickier.

    Michael Greenberg’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.