The yield curve has been garnering a lot of attention as long-term government bond yields have been falling below some shorter-dated bonds as a result of slower global growth and lower inflation expectations. However, for a brief period Wednesday, the yield on 10-year U.S. Treasury bonds dipped below the two-year U.S. Treasury, as weak data out of Germany and China fueled concerns about a possible economic downturn. Historically, the shape of the yield curve has served as an indicator of a coming recession. But, let’s take a look at what this inversion may be signaling.
A History of Yield Curve Inversions
As illustrated in Exhibit 1, a recession has been known to follow an inverted yield curve within 18-24 months. The five last recessions, which were preceded by an inversion of the yield curve, included September 1978, September 1980, January 1989, February 2000 and February 2006. However, the degree and length of the inversion is an important indicator of an eventual recession. In these previous occasions, the inversion was at least 25 basis points and lasted at least three months. There has been one time period, June 1998, where the inverted yield curve was not that long or severe, and a recession did not materialize within the 18-24 month timeframe.
Is This Time Different?
In addition to history as a guide, we believe this inversion could be different as the shape of the yield curve has been driven mostly by global supply and demand factors, rather than a weak U.S. economy. One of the major factors influencing the shape of the yield curve, as well as the general level of both domestic and global rates, is the massive quantitative easing programs implemented by many of the world’s central banks. This has resulted in artificially low and/or negative yields globally. Lastly, the 10-year U.S. Treasury yield has decoupled from being a gauge of future economic growth and inflation, and instead has become tethered to low global rates as seen in Exhibit 2. Thus, the predictive powers of a yield curve inversion may not be as relevant this time around.
Low Risk of U.S. Recession
A strong jobs market, a healthy consumer sector, which contributes to 70% of gross domestic product, and lower rates should help the U.S. economy deliver near-trend growth this year and next. In addition, we expect the Fed will likely deliver two to three additional 25 basis point rate cuts this year, helping to stabilize growth.
That said, the inversion should not be overlooked, especially since it is hard to predict the outcome and impact of current trade tensions given the lack of precedents. But for now, we think the U.S. expansion will continue and investors should benefit from an overall neutral equity positioning with a bias toward domestic equities. Within bonds, despite this significant decline in interest rates, we continue to recommend close to neutral duration and high-quality, intermediate maturities within an investor’s core fixed income holdings. We caution investors on being too predictive of where U.S. interest rates will go as global rates will continue to act as an anchor. We remind investors of the diversifying role fixed income plays within a portfolio, especially in periods of equity market volatility. We will continue to watch the length and magnitude of the inversion as well as economic data that may impact our outlook.