- The US yield curve is flattening, a normal scenario at a time when the US Federal Reserve is lifting interest rates.
- When the curve has turned negative in the past — where short-dated yields are higher than for longer-dates — it has almost always indicated that a recession will occur within two years.
- Macquarie Bank doesn’t expect the curve to turn negative until the end of 2019, but it says 2020 will be a “most interesting year”.
Nearly a decade after the worst economic downturn since the Great Depression, markets are now starting to think about when the next US recession might hit.
The US yield curve — the difference between short and longer-dated bond yields — is continuing to flatten, and may go negative in the not-too-distant future.
While not unusual at this point in the economic cycle — the Fed has been hiking interest rates for several years now seeing shorter-dated yields rise in response — the continued narrowing in yield differentials has clearly got some people nervous, particularly as the Fed looks set to continue tightening monetary policy for some time yet.
The higher shorter-dated yields rise, the higher the probability that the curve will turn negative.
As Macquarie Bank notes, this has almost always signalled that a recession will follow.
“Over the past month the US yield curve has resumed the rapid flattening observed since 2014 with the 2s-10s spread falling to 45 basis points, the narrowest seen since late 2007. If history is any guide, once the yield curve inverts we should begin the countdown to the next recession,” it says, pointing to the chart below.
“The yield curve has inverted within the 24 months preceding each of the past five recessions, and has only inverted once without a recession following in the ensuing two years.”
While some might question the wisdom of the Fed continuing to lift interest rates given that track record, seemingly pushing the US economy towards another recession, it is lifting rates to ensure that a boom-bust economic cycle doesn’t arrive in the years ahead.
With financial conditions still easy compared to historic norms, a labour market that is incredibly tight and fiscal stimulus only just starting to filter through the economy, it is taking action to ensure that imbalances in the US economy don’t reach extreme levels.
One only has to look back to the last economic downturn — the GFC — to see the consequences of allowing policy settings to remain too loose for too long.
With the economic scars of that crisis now only freshly healed, it hardly wants to deal with a similar scenario when the next downturn hits.
As such, Macquarie thinks the Fed will continue to hike rates quite aggressively over the next two years, an outcome that should see shorter-dated yields continue to increase, further flattening the yield curve.
However, it doesn’t expect it will turn outright negative for some time yet.
“We expect the two-year yield to continue to rise, as the Fed increases the fed funds rate another three times this year, and a further three to four times next year,” it says.
“However, as we also expect 10-year yields to resume their gradual upward trend, moving above 3% in the September quarter this year, [meaning] we don’t believe that an imminent yield curve inversion is on the cards.
“We expect the 10-year to remain 15 basis points above the 2-year in the final quarter of 2019, with the 10-year having increased to 3.75% and the 2-year at 3.6%.”
Macquarie doesn’t expect the curve to completely flatten until the end of 2019.
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While this, based on history, suggests an economic downturn will probably arrive by the end of 2021, it doesn’t expect that the US economy will slow down by any significant degree over the next couple of years, forecasting that US growth will remain “robust”.
“There is no evidence that growth systemically slows as the spread approaches zero. Rather, the sudden and normally unanticipated dip into recession has always followed the inversion by a significant period,” it says.
“It is also possible that the relationships between activity and the curve will be less direct in this cycle as long yields in the US are being restrained by [ultra-loose] central bank policy elsewhere.
“This, along with the fiscal stimulus, suggest that the risk of recession in the next year or two remains low.”
However, even with uncertainty as to whether quantitative easing by other major centrals banks is distorting the signal generated by the flattening yield curve, Macquarie says that 2020 is shaping up as a “most interesting year” for the US economy.
“On recent trends, bond markets are suggestive of a recession beginning in 2020 or 2021,” it says.
“This is expected to coincide with the growth impulse from US fiscal stimulus subsiding and a Presidential election in the US, which could be a catalyst for a slowdown in US.”
Even if such a recession does occur around this period — something that is not guaranteed by any stretch — it would still leave the current US economic expansion as the longest on record.