Help! The yield curve has reverted

Is recession knocking at our door?

Article updated: 25 March 2019 12:00pm Author: Michael Baxter

The yield curve has reverted, meaning that long-term interest rates have fallen below short-term rates, and that means, or so we are told, that a recession will follow, like night follows day.

I can say one thing for sure. There will be a recession. Whether the next one will begin next Tuesday, or towards the end of this century, I can’t really say, but it will probably be some point between those dates, and probably within a few years. I am not saying anything special here, simply describing the usual rhythm of the economy, in much the same way a climate observer might say we get winters and summers, or an especially schrewd observer of the heavens may have noticed: night follows day.

But the reversion of the yield curve is meant to be a more specific forecaster of recessions. It means that investors have such little faith in the future that they will accept a lower return on their cash over a longer term than over the short term.

And if you want to be even more specific; it is defined as the yield on US ten-year Treasuries being lower than the yield on two-years.

It happened in 2007 — so that was pretty prescient. But it also happened in 2004, maybe this is the flaw with the theory.

The conundrum

Alan Greenspan, chair at the US Federal Reserve for 19 years up to 2006, called it a conundrum. As his time at the Fed was drawing to a close, something odd happened; the yield curve went negative — it reverted, but the man who, at that time was called the maestro, who seemed to bask under a halo that shone so bright that economic commentators appeared to be able to see it from Washington to the other side of the world, didn’t think a recession was imminent.

He may have called it a conundrum, but actually he had a good explanation for why it had happened. It was that globally, thanks to a number of issues including demographics and the rise of China, there was a savings glut. There was simply too much saving chasing too few locations for the savings. What was called the carry trade, when Japanese investors fed up with very low interest rates at home, ploughed cash into assets abroad, was another factor.

What we can say is that the 2004 reversion of the yield-curve was not an harbinger of an imminent recession. But when we did get a recession in the US, three years or so later, it was one mother of a recession. Maybe the 2004 reversion was not so much a conundrum as a harbinger of recession, but with a lengthy time lag.

2019

Well, it has happened again.

Does this mean recession is around the corner? And how far off is the corner? If night follows day, is it like the night time they get in the Arctic in midsummer — 24 hours of daylight?

The next US Presidential election is in 2020, will it happen before or after then?

Oddly, some of the economic data out in the last couple of weeks is vaguely encouraging. Purchasing managers indexes suggest that the UK and eurozone economies are crawling along bottom, but that the economies seem to be avoiding recession; the latest flash PMI pointed to 0.2 per cent growth in Q1. The UK composite PMI suggested growth at 0.1 per cent in Q1.

The PMIs tracking the US economy are consistent with annualised growth of 4.0 per cent.

So, actually there is little evidence of an imminent US recession in the data.

In the eurozone, Spain is growing at a brisk pace, the closely watched German Zew index surged in March. To me, it felt like a mid-cycle slowdown than a recession.

Brexit and end of stimulus

But the US government has already fired its bazooka, tax cuts on the wealthy. There isn’t much scope for more stimulus.

The interest rate cycle has either run its course, or is on hold.

And as for Brexit, err hum hum, I don’t want to say ‘told you so,’ but I did. Unless sanity returns to the UK, we are set to see big job losses.

Unfortunately, a lot of the job losses will be in areas that are quite well paid. Exporters, who are the biggest corporate critics of Brexit, tend to be among the most productive companies.

What next?

The inverted yield curve may be misleading.

Writing for Bloomberg, Mohamed Aly El-Erian, former CEO of PIMCO said: “When it comes to the direct economic and markets effects, this curve inversion is unlikely to be the traditional signal of a US recession.”

But he warned: “That doesn't mean policy makers should relax. Instead they should be even more motivated to press forward with pro-growth measures such as infrastructure modernisation and rehabilitation as a means of reducing the risk of self-fulfilling expectations operating through the financial asset channel.”

What about investors?

Markets should see a sell-off before a recession, but then we saw such a sell-off last year, but the S&P 500 is close to a full recovery, in the midst of Brexit divided Britain, the FTSE 100 isn’t.

I would say now is a time for care, I foresee buying opportunities ahead.


These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

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