Curmi & Partners

The inverted yield curve may be misleading

by Matthias Busuttil

Economic growth for the second half of 2019 has long been anticipated to be weak by market participants and policymakers across global economies. However, the heavy gloom that is being priced into bond markets does not seem to fully reconcile with recent economic data and what leading indicators are pointing at.

The rally in government bonds of developed economies, which accelerated in August, has pushed the differential between long-term bond yields and short-term bond yields to very low levels, or even negative in the case of US, UK and Canada where the yield curves have inverted, signalling increasing fears by investors of severe economic deterioration on the horizon.

Prima facie, it is easy to justify the drop in bond yields. This week, the export-oriented German economy reported a contraction of -0.1 per cent in the second quarter of the year mainly due to shrinking industrial and automobile exports. China printed weak data, specifically retail sales and industrial output which came in below expectations. The US ISM manufacturing index has also weakened over the recent months.

These pieces of data are received in a macro back-drop of escalating trade-tensions between US and China, the increasing  probability of a “no-deal” Brexit and political and economic issues flaring up once again in Italy.

Investors have been seeking refuge in safe haven assets which spurred a sizeable drop in long-term government bond yields which most notably led to the inversion of the US treasury curve.

The predictive power of yield curves is waning

The movement in the US yield curve has been fretted upon by many given that inversions have been a warning indicator of marked decelerations in economic growth in the past. And while this has been the case in previous economic downturns, yield curve inversions tell us little about the timing of a recession – historically this has ranged between three months and three years after the inversion.

Secondly, it may be worth remembering that this is the first time that the curve has inverted while the Fed has already shifted somewhat towards a loosening stance by delivering an ‘insurance’ rate cut in July and halting the rundown of its quantitative easing holdings. Although Jerome Powell, the Chair of the Federal Reserve, defined the decision as a “mid-cycle adjustment”, a lot of evidence suggests that more needs to be done.

Thirdly, the US yield curve inversion comes in a period following an unprecedented degree of quantitative easing across developed economies which may have impaired the predictive ability of yield curves. Central banks have exerted greater influence on long-term yields through unconventional monetary policy which led to strong trends in domestic and foreign buying of sovereign bonds. The resulting flattening effect could distort the signalling power of the yield curve as long-end yields were pushed lower while short-end rates remained relatively anchored to the central bank’s policy rate.

Lastly, a long drawn underlying trend may have developed which gradually lowered the theoretical neutral rate of interest thus resulting in a potential dislocation in current short-term policy rates. More light may be shed on this matter when the Fed (as well as the ECB) completes the policy framework review.

Let’s not forget the role that policymakers have yet to play

Although the recession signals should not be dismissed, let’s not forget that policymakers are expected to do more in a bid to sustain economic growth and avert a recession. To this end, the recent US budget deal which suspended the limits on government borrowing has removed the risk of fiscal tightening, at least for the time being.

The Federal Reserve on the other hand has a growing list of reasons to loosen monetary conditions now rather than later.

The first reason is the inversion of the US yield curve itself. The New York Fed’s recession indicator, which runs off the shape of the yield curve, is showing the highest probability of a recession since the great financial crisis.

Secondly, the trade war against China was identified by the Fed as a key downside risk factor, the escalation of which is increasing the Fed’s assessment of the potential adverse impact on the economy especially following the recent retaliation by China on halting US crop purchases.

Thirdly, inflation expectations in the US have dipped lower and remain well below the Fed’s target. Moreover, the Fed may be becoming more compelled to eye the strength of the US dollar given the relative currency weakness in other countries which can be disadvantageous to the economy.

Finally, the Treasury’s financing requirements are likely to lead to tighter financing conditions in the US dollar funding market. As the treasury seeks to replenish its cash balances following the removal of the debt limit, the elevated level of supply expected to come to the market will lead to rising funding pressures that can swell short-term spreads which the Fed can only alleviate by cutting rates.

A slowdown is more likely, but recession risks remain

Given the current US economic fundamentals and an accommodative policy stance by policymakers, the expectations are for a slowdown in economic growth while a recession is likely to be averted in the short term.

However, the risks of a rapid deceleration and potential recession remain. Although the trade tariffs are not expected to have a sizeable impact on US GDP, especially given the depreciation of the renminbi, the potential indirect impact on business sentiment and investment can have a second round effect on the US economy.

Moreover, a potential misstep by the Fed in seeking to maintain easy monetary and financing conditions could fall short of what the economy requires to remain afloat.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.