As if there were not enough for markets to fret about. US inflationary pressure and rising costs are eroding corporate margins, offsetting any benefit of falling unemployment rates and rising wages. Overall, the data generally remains mixed, but when the spread between the two-year and ten-year yield curve inverted (downward sloping) in April, money managers began to take notice.
An inverted US yield curve, which occurs when long-term yields fall below those offered by shorter maturities, has often served as a leading recession indicator, with a lag of about four to eight quarters. Prior to April this year, the curve last inverted in 2019, amid slowing foreign growth and the waning effects from US stimulus.
While that warning proved inconclusive because the subsequent recession was mainly due to the Covid-19 pandemic, the previous two occurrences offered some foresight. Long-term yields fell substantially below their short-term counterparts prior to both the 2008 financial crisis and the 2001 dot-com bubble.
Historical similarities or new reasonings
Since the start of modern markets, the US treasury curve has inverted 28 times with a recession following in 22 instances, according to Gary Kirk, Founding Partner at TwentyFour Asset Management speaking to FinanceAsia.
If history were to repeat itself, a US recession could spell trouble for global markets already grappling with weak world demand. In July, the International Monetary Fund (IMF) downgraded its economic outlook forecast for the year amid stubborn inflationary pressure. Global growth has also had to contend with a slowdown in China, which expanded just 0.4% in the second quarter of this year, barely missing a contraction.
“However, not all recessions are severe,” noted Kirk, pointing out that the US was already in a technical recession after two consecutive quarters of negative economic growth. “Recessions are more meaningful when followed by a spike in corporate defaults and rising unemployment.”
In that regard, recessions are harder to quantify, particularly as global markets and world economies become more integrated, according to Jason Ho, Asia Head of Capital Solutions at FTI Consulting speaking to FA.
In the current environment, “inflation is supply driven, not demand driven, and rising interest rates do create more issues, rather than resolving the initial problem,” explained Ho. “Therefore, excessive market liquidity and elevated gross debt are certainly contributing to the effectiveness of these indicators,” he added.
Years of quantitative easing and central bank balance sheet expansion have pushed the long end of the yield curve lower in order to disincentivise savings. When the Federal Reserve tapers and shrinks its balance sheet, the impact should reverse, and longer yield should subsequently rise.
The current tapering policy coincides with the Federal Reserve’s push to raise interest rates to tame inflation, which promptly impacts the shorter end of the yield. Comments by Federal Reserve Chair Jerome Powell at the Jackson Hole Economic Symposium last week re-emphasised the central bank's focus to bring inflation back down to its 2% goal. This could suggest that the current inversion might reflect policy timing and priorities, and less so act as a dire economic precursor.
Any single barometer used as a recession metric draws mixed reviews, especially since there is also an element of a self-fulfilling prophecy that can be explained. Because the yield curve is a measurement of borrowing costs, if the expectation that near-term borrowing will be more expensive amid prospects of weaker growth, there is little incentive to lend. This indirectly facilitates a slowdown.
Ariel Bezalel, investment manager at Jupiter Asset Management highlighted to FA that because “numbers can, by nature, be subject to bias, some relationships might not hold anymore due to structural changes or idiosyncratic differences." Technological innovation creates a deflationary impact, he posited, as does a global aging population. Asia’s savings glut too, has harnessed demand for US treasuries, keeping yields lower.
Market specialists are not only reconsidering what factors to analyse, but also how best to analyse existing metrics. Kirk believes that it is better to focus on the shorter end of the curve, particularly the spread between three-month and 2-years costs.
“Because global supply chain disruptions have a significant impact on inflation, this holds a more meaningful impact to any changes in the rate hike cycle being reversed in a relatively short period of time,” said Kirk, echoing the same view put forward by the Federal Reserve back in March.
Most agree that the yield curve’s shape should be seen as a part of the overall aggregate data pool and not as a single barometer. Economist Paul Samuelson famously quipped that the stock market had predicted nine out of the last five economic recessions, implying its bearish pessimism about the economic outlook.
A slew of factors including exchange risks, commodity prices, and geopolitics also contribute to the sentiment determining whether economies will recede. But it should go without saying, that markets have been warned to proceed with caution, especially given that the three-month and two-year curve is narrowing closer to zero.