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The Federal Reserve Board, whose building is seen here on Constitution Avenue in Washington, suggested that the unprecedented wave of quantitative easing undertaken by central banks around the world may have contributed to the flatter yield curve for Treasury bills. Photo: Reuters
Opinion
Macroscope
by Hannah Anderson
Macroscope
by Hannah Anderson

The bond market flashes a ‘recession warning’, but it’s not time yet to panic

  • An inverted yield curve typically precedes a worsening economic outlook, even a recession. But this time, as yield on 10-year Treasuries dipped below that on the three-month bills, many other factors were at play. There’s no guarantee a recession will follow
Hannah Anderson
Hannah Anderson
Why you can trust SCMP

The bond market has started to flash what could be a warning sign as interest rates on longer-term United States government bonds – also known as Treasury bills – fall below those on short-dated bonds. This phenomenon is known as a yield curve inversion, and often signals a worsening economic outlook in the medium term, or even a recession.

Investors often compare the interest rates, or yields, on shorter-dated Treasury bills – such as those maturing in three months or two years – with those on longer-dated bonds maturing in, say, a decade, as this spread can offer important information on what to expect in the near term versus the long term.

An inverted yield curve certainly contains important information, but the movements of Treasury bills this week may not necessarily be harbingers of doom. It matters a great deal which part of the curve is inverted.

On May 23, the spread between the yields on three-month and 10-year Treasuries turned negative. However, the spread between the two-year and 10-year Treasuries has not – and it is this spread that is most commonly referenced when watching for a yield curve inversion.

Still, it is worth noting that the spread between two-year and 10-year Treasuries remained in the 14 to 18 basis points range, where one basis point refers to 0.01 of a percentage point. At this range, the spread is hovering near its lowest levels since the global financial crisis and the last US recession. In the lead-up to prior recessions, this spread has often gone into inversion before or concurrently with an inversion in the spread between the aforementioned three-month and 10-year Treasuries.

An inverted yield curve in the two-year to 10-year Treasury spread has preceded every US recession since 1965. However, not every such yield curve inversion has been followed by a recession. In the late 1960s and 1990s, the two-year to 10-year spread inverted but no recession came within the next few years. More importantly, when such a yield curve inversion precedes a recession, it tends to do so by an average of 14 months, compared to 15-18 months for a three-month to 10-year spread inversion.

Historically, yield curve inversion is also taken as a signal that bond investors are feeling more upbeat about near-term growth than they are about the long-term prospects of the US economy. This could reflect a view that an ongoing increase in policy rates would eventually put a brake on economic growth, resulting in a recession. Ahead of recessions, the US equity market typically peaks and then enters a bear market.
Because equity markets often peak between an inversion and a recession, there is a cost to getting too spooked by narrow spreads. Between the last three-month to 10-year spread inversion in March and this most recent inversion on May 23, the S&P 500 returned 1.5 per cent in price terms.

While that is not a stellar return by any means, at one point in that period investors were up by 4.6 per cent. The yield curve does not tell us everything we need to know about equities and there were several discernible factors outside of recession fears, moving both equities and bonds over that time such as financial conditions, political turmoil, and trade tensions.
While I am always loathe to say this time is different, we do have to consider a few more factors that were absent from previous inversions. One factor is the quantitative easing undertaken by major central banks around the world, a move that could have distorted the shape of the yield curve.
Brewing trade tensions between China and the US also has an effect on movements in equities and the bond markets. Photo: Reuters

The US Federal Reserve acknowledged this at its June meeting last year when Fed officials discussed whether a flatter yield curve could be brought by a number of factors, including “a lower level of term premiums in recent years relative to historical experience reflecting, in part, central bank asset purchases”.

This is not just purchases by the Fed. Quantitative easing by other major central banks around the world could have altered the behaviour of their respective institutional investors, and pushed them to allocate more capital in US Treasuries, keeping yields closer to zero than they otherwise would have been.

The Treasury yield curve inversion may be less of a guarantee of impending recession, than a reflection of equity jitters induced by the trade war, safe haven flows into less risky bonds, and the curve distortions of central bank policies in the last decade. Even if it is a harbinger of a slowdown, the lag time before recession kicks in tends to be elongated.

That said, with the US getting into even later cycle, many of the biggest worries for this year, such as slowing global growth and trade tensions, do not look to be going away. Alarm may be premature, but caution is warranted.

 Hannah Anderson is a global market strategist at JP Morgan Asset Management

This article appeared in the South China Morning Post print edition as: Not time yet to panic despite recession signal in bond market
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