- Concerns about a looming US economic slowdown, or worse, have intensified in recent months, fuelled in part by some worrying signals being generated by the bond market.
- In the past, whenever longer-dated US bond yields have fallen below shorter-dated equivalents, it’s almost always acted as a precursor to a recession.
- A lot of investors have been reading up about yield curve inversions recently, increasing the risk of a sell-fulfilling prophecy occurring.
- BAML’s global economist outlines why he is trying to “talk investors out of this funk”.
Concerns about a looming US economic slowdown, or worse, have intensified in recent months, fuelled in part by some worrying signals being generated by the bond market.
The US yield curve has been flattening, or in some parts gone inverted, painting a worrying picture about the direction that economic growth is heading.
Currently, the differential between 10-year treasury yields and 2-year treasury yields sits at just 16 basis points, only marginally above the single-digit levels seen earlier in the month.
In the past, whenever 10-year yields have fallen below 2-year equivalents, a recession more often than not follows soon after.
Given the yield curve’s excellent track record, it’s easy to see why markets are getting nervy, dumping stocks and pricing out the prospect of a series or rate hikes form the US Federal Reserve next year.
Ethan Harris, Global Economist at Bank of America Merill Lynch (BAML), can understand why investors are nervous.
“A common refrain is that yield curve inversion is the best predictor of recessions. Indeed, inversions have preceded each of the last seven US recessions,” Harris says.
“This historic fact has created an ugly feedback loop in investor sentiment: concerns about the economy and stocks have triggered lower bond yields, which have triggered worries about curve inversion, which in turn have triggered further stock market weakness, and so on.”
As seen in this simple-yet effective chart, many people have reading reading up on signals from the yield curve of late.
So with markets now well aware about what a yield curve inversion has forewarned about in the past, this knowledge carries the potential to create a sell-fulfilling prophecy where a recession eventuates because enough people believe a recession will occur.
Essentially, they start behaving like a recession will hit, exacerbating the potential for a growth slowdown.
Harris doesn’t want to see such a scenario play out, outlining why he is trying to “talk investors out of this funk”.
In particular, he says the disappearance of term premium in the bond market — the extra interest investors demand for providing longer-term funding — means inversions should no longer be remarkable events.
“If the inversion story were really as powerful as some suggest, QE by central banks would have been a huge policy mistake,” he says, referring to massive bond-buying programs rolled out by major central banks following the GFC that were designed to lower long-term borrowing costs.
“If big balance sheets do indeed lower term premiums then they make inversions happen much more often. Indeed, perhaps central banks should stop trying to ‘twist’ the long end of the yield curve lower, but instead should try to twist it higher.
“We don’t agree with any of this, but it is the reduction ad absurdum of focusing too much on the yield curve.”
Harris says that while the flattening of the yield curve shouldn’t be ignored, he stresses that the slope of the curve is just “one of many signals from the markets to the economy”.
“Broader financial conditions are still quite accommodative and the extent of recent tightening is modest relative to shocks that occurred earlier in this cycle,” he says.
“Our baseline expectation is that the various political risks facing the markets right now — most notably the US-China trade war, Brexit and Quitaly — will reach a relatively benign resolution.
“In this case we would expect financial conditions to ease once more, supporting a continuation of the business cycle.”
As such, Harris doesn’t expect the doom and gloom towards the US economic outlook will be replicated in reality.
“Economic bears will have to stay in hibernation a little longer,” he says.
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