- The spread between the yield on US 2-year government bonds compared to 10-year treasuries is holding at decade lows.
- When 2-year yields exceed 10-years (described as an inverted yield curve), US recessions have often followed.
- But AMP chief economist Shane Oliver suggests there are “several complications” for whether that will be the case this time.
The current US economic expansion is now over 100 months old, around double the average length of time since the second world war.
As a result, there’s been an increasing amount of market chatter about when the next recession will arrive.
A lot of that debate has been framed around the spread in US government bond yields. If the yield on shorter term 2-year bonds rises above that of benchmark 10-year treasuries, it’s known as an “inverted yield curve”. And when that happens, recessions usually follow.
Right now, the 2-10 spread is hovering at a decade-low of around 25 basis points (0.25%).
In his latest research note, AMP chief economist Shane Oliver said there are “several complications” when it comes to using the inverted yield curve as a fool-proof recession indicator.
For one thing, he noted the yields on both 2-year and 10-year bonds have been rising this year as the US Fed tightens monetary policy, but 2-years have been rising faster.
“A flattening yield curve caused by rising short term rates and falling long term rates is arguably more negative than a flattening when both short and long term rates go up,” Oliver said.
In addition, the US Fed has said itself that instead of the 2-10 spread, the gap between bond yields and the Fed’s own cash rate is a better barometer.
US interest rates are currently in a range between 1.75-2%, with 10-year bond yields trading today at 2.88%. The spread has closed in, but it’s still at a comfortable gap of around 1%.
And since the Fed commenced raising rates in 2014, 2-year bond yields have been rising at a quicker pace which Oliver said is a positive sign.
The strength of the correlation between yield curve inversion and recessions is also shaken somewhat by the fact that relative time-frames for a downturn are hard to pin down.
When inversions occurred in 1986, 1995 and 1998 it was another 15 months before a recession hit. So on the current time-line, if a follow-up recession does occur it may not happen until 2020.
Lastly, could this time be different? Although those are famous last words in financial markets, Oliver said other unique factors may be contributing to the flatter curve, outside of US growth expectations.
He cited the subdued outlook for long-term inflation, low bond yields in Germany and Japan serving to hold down US yields, and increased demand for bonds in the wake of the 2008 financial crisis.
Furthermore, the current economic expansion can be characterised by its slow and steady pace. In turn, the Fed hasn’t been forced to slam on the brakes with faster rate hikes.
And despite the long duration of this cycle, there are multiple signs the US economy isn’t overheating yet.
Annual wage growth is still just 2.7%, while the last three recessions were preceded by wage growth of over 4%.
And at 1.75-2%, the current Fed cash rate is below the latest reading for annual inflation, whereas interest rates prior to recessions were often well above that.
Oliver agrees with the general consensus that the Fed’s current tightening cycle will give rise to more market volatility. But a US recession is “still a way off”.
“We have been thinking recession is a 2020 risk,” Oliver said. However, “with 2020 being the consensus pick for a downturn, the risk is that it comes later”.
In view of that, “the US and global share bull market likely still has some way to go”.
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