Monthly outlook for January: Stop whining about the US yield curve
Talk of an inverted US yield curve flagging a recession is completely misplaced, says Robeco investor Lukas Daalder.
• Flattening US yield curve has triggered misplaced recession concerns
• Flatter curve does not reflect lower growth, inversion is no sell signal
• The steepness of the yield curve is a non-issue for investors in 2018
Fears have grown that a flattening in the curve that depicts the difference in yields between shorter-dated and longer-dated government bonds are a bad omen. “This has triggered a lot of concerns, with people claiming that this is a sign that US expansion is coming to an end,” says Daalder, Chief Investment Officer of Robeco Investment Solutions.
“People are worried mostly because since the mid-1970s, all recessions have been preceded by a period when the yield curve was inverted, meaning that the 10-year yield was lower than the 2-year yield. This correctly signaled five out of five recessions: neither economists (‘zero out of the last seven’) nor the stock markets (‘nine out of the past five’) can boast such a strong track record of predictions.”
“So although this does look like a reliable leading indicator, there are a number of reasons why we think the whole ‘a-recession-is-around-the-corner’ theme is overdone right now.”
Beware of false signals
Daalder says firstly, the notion that an inverted yield curve is an early warning system is not infallible, particularly if the bond durations used are changed, as shown in the chart below. “Things look somewhat different when we extend the timeframe, such as by switching from a 2-year Treasury yield to a 3-month interest rate,” he says.
“Here we now have two false signals: neither the inversion of 1966, nor that of 1998 were precursors of a recession. Not every inverted yield curve ‘leads’ to a recession, apparently. It is clear that the yield curve has not always acted as a reliable early warning system, and it can be questioned whether in this day and age of central bank intervention in bond markets, it still has the same predicative qualities that it used to have.”
So why does this fear persist, when the US is nowhere near an inverted yield curve using either 2-year bonds or 3-month rates at the short end? It stems from the Fed signaling that it expects to make three quarter-point rate hikes in 2018, which would bring policy rates above 2% for the first time since 2008, Daalder says.
“If you add the 75 basis points of rate rises to the 2-year yield while keeping the 10-year yield unchanged, voila! … you end up with an inverted yield curve,” he says. “If only things were that simple. There are a number of important assumptions being made here, all of which can be questioned.”
How many rate hikes?
“First, in recent years we have seen that the Fed’s expectations are usually too optimistic when it comes to rate hikes. Not surprisingly, financial markets only expect rates to rise by 50 basis points, as can be deduced from the December 2018 Federal Funds Future.”
“Second, the link between the Federal Funds rate and 2-year yields is fuzzy at best. But by far the biggest – and the mostly unlikely – assumption however is that 10-year yields will remain unchanged during 2018. This would imply that the Treasury market will not be affected by the steady unwinding of the Fed’s bond holdings, along with other issues such as the Trump tax cuts and a tighter labor market.”
“In other words, the Fed would be raising rates as a result of an ongoing improvement in growth, but we are assuming here that bonds would not be impacted by that same underlying momentum improvement. This is a story that does not sound very plausible.”
18-month time lag
Daalder says that even if the yield curve does eventually invert, this still does not mean that a recession is around the corner. “Historically, on average it has taken another 18 months before the recession started,” he says. Given the fact that stocks typically start their descent four months prior to a recession, it is clear that this is not a very reliable sell signal, at least for the time being.”
“Another misnomer is that the steepness of the yield curve is an indicator for the underlying strength of an economy. If this is indeed true, then it is clear why there is rising concern about the flatter yield curve: the flattening would signal an even lower growth rate than the one we have seen in recent years.”
“However, historically there has not been a clear-cut relationship between the two. Neither in the late 1980s, nor in the late 1990s, did the flattening of the yield curve coincide with a lower growth rate; instead, it coincided with a higher one. In fact, looking at growth and the yield curve during the current expansion phase, one might even claim that the relationship seems to have been inverse.”