- Nomura is negative about the outlook for the global economy, like many others at present.
- The possible inversion of the US yield curve in the near-term is making people worry about a looming recession given its tarck record over previous economic cycles.
- Strategists at the bank says its not the actual inversion of the curve that markets should worry about, but rather when the inversion bottoms out and the yield curve starts to steepen.
Nomura is negative about the outlook for the global economy, like an increasing number of investors around the world right now.
However, Andy Chaytor and Sam Bonney, strategists at the bank, want to put an an end to a common misconception about the signals currently being generated by the US bond market: an inverted US curve — where longer-dated bond yields fall below shorter-dated equivalents — doesn’t automatically set the countdown clock for the next US recession.
“We are negative on the global economic outlook and believe the market will move towards pricing a sub-trend growth phase in the months ahead,” they say.
“But we want to put to bed the idea that an inverted yield curve automatically guarantees that a recession is around the corner.”
On Thursday, the spread between US 10 and 2-year treasuries fell to single digits, marking the flattest the curve has been since 2007.
We all know what happened next — the largest global economic downturn since the Great Depression.
Chaytor and Bonney understand why some investors are fretting given the track record for yield curve inversions for predicting looming recessions, but they believe it’s misunderstood.
“The yield curve tends to move closely in line with the business cycle,” they say.
“This is because when the output gap is positive central banks tend to run tight policies to stem inflation pressures. A positive output gap means spare capacity in the economy is limited.
“An economy can’t run a positive output gap forever — business cycles tend to mean revert. Therefore, it is unsurprising that yield curve inversion tends to come before recessions.”
A positive output gap occurs when an economy is growing above its potential trend rate, leading to inflationary pressures, lower unemployment and tighter monetary policy as central banks attempt to slow activity to prevent potential boom-bust economic cycles.
That’s exactly what the Fed has been doing since late 2015, lifting its funds rate on eight separate occasions to date. That has seen shorter-dated yields lift as a consequence, narrowing the spread to longer-dated bond yields and a flattening of the curve.
Chaytor and Bonney say this is a clear sign the US approaching the end of the current economic upswing, but not a subsequent recession.
“A flat or inverted yield curve is confirmation we are in the late stage of a cycle, but does not guarantee a recession is around the corner,” they say.
“In some cases, inversion may indicate that monetary policy is too tight and will cause a recession.”
With markets scaling back expectations for Fed rate hikes next year in the past few weeks, now pricing in the likelihood of just one hike rather than two or maybe three as was the case just a couple of months ago, and with senior Fed officials also offering a more cautious tone in recent commentary, Chaytor and Bonney suggest the risk of the Fed tightening aggressively next year — leading to a potential policy mistake — has diminished as a result.
“The market is not pricing a policy mistake yet,” they say.
“The recent shift in Fed Chair Powell’s stance suggests the Fed is unwilling to tighten policy far above neutral.”
As for when the next US recession is likely to occur, the pair say it’s not when the actual inversion of the curve, but rather when it bottoms and starts to steepen again, that investors should look out for.
“The time to get bearish is at the trough of the flattening trend, at which point below-trend growth is conducive to less positive output gaps and yield curve steepens,” they say.
“This is the real recession trade!”
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