The US Treasury yield curve is still inverted, historically a sign of an upcoming recession. When yields are higher for short dated bonds compared to their longer duration counterparts, this suggests that investor sentiment is negative about the current state of the economy and exhibiting a ‘flight to quality’ in the form of a 10-year US Treasury (UST).
The gap between the yields of a three month and ten year UST may have narrowed during the month to four basis points from a height of 18 basis points but the fact remains that investors are still getting higher yields on a three month.
Given that the US economy is growing at over three percent and unemployment is at a 50 year low albeit with a slight uptick last month, it doesn’t appear that the country is on the precipice of recession. However, both GDP growth and unemployment are indicators of what has happened in the past, with unemployment statistics being a typical ‘lagging indicator’ of the economy.
Yield curves offer a glimpse into the future, and if investors are piling into 10-year USTs, it is driving up the price which by definition inversely lowers the yield. The reverse impact occurs if short dated USTs are shunned, becoming cheaper with higher yields.
Don’t fight the Fed
Can interest rate cuts help the situation? From a purely mechanical point of view it would seem likely, however current Fed Chair Jerome Powell has stated his interest rate policy is ‘data dependent’ so any cuts are likely to be interrupted as harbingers of bad news. However, the story gets a little more complex when the fact that 2020 being a Presidential election year comes into play. Donald Trump has been trumpeting for interest rate cuts for some time and Mr Powell’s U-turn from previous policy statements has certainly aided risk assets this year.
However, while equities have certainly recovered from Q4 2018, there are still areas which may cause some to ponder how much growth is left in the global economy. The US-Sino trade war rhetoric combined with Brexit uncertainties and the EU aren’t exactly conducive to a growth environment and perhaps this is reflected in the inverse yield curve.
What the experts think
Deutsche Bank recently released research into Fed interest cutting cycles and the results were hardly optimistic. It found that since the 1950s, the Fed has embarked on 19 interest rate easing cycles, including the unconventional easing measures adopted during the course of this economic recovery. The latter policy also dubbed extraordinary monetary policy being a reference to quantitative easing.
The research found in almost half (9) of cutting cycles, the economy eventually fell into recession. Furthermore in these recession episodes, the S&P 500 saw a full bear market, typically falling 27% from peak to trough, with a bulk of the decline occurring after the Fed had started cutting rates. The bank also found on average, the S&P 500 did not bottom until 5 months after the Fed started cutting.
The yield curve was inverted during previous US recessions as well, in the early 1990s, 2001 and the global financial crash of 2008. However, during the 1991-1992 recession, the Fed started cutting rates during the event to stimulate investment. This would be more difficult with today’s target rate of between 2.25% and 2.5% but it still has some wiggle room compared to other developed markets where rates are close to zero.
Gaining exposure to USTs is comparatively easy for investors, with wealth managers tending to use low cost ETFs to access this highly liquid asset class. While these products would be difficult to use to track very short duration USTs of three months, they are more suited to longer maturity bonds such as 10-year USTs. This is not to say that this explains away the money flowing into 10-year USTs and the resulting yield inversion although one popular product, Lyxor’s Core US TIPS ETF tracks a basket of USTs with a range of maturities but is more weighted towards the longer end of the curve. This ETF has assets nudging £2 billion.
