Some Thoughts on US Yield Curve Inversion

A portion of the US yield curve has inverted. While this is not the typical inversion that presages a recession, markets are nevertheless on heightened alert. This piece will discuss the predictive power of an inverted yield curve as well as why we are not yet concerned that one will materialize.

RECENT DEVELOPMENTS

The 10-year yield broke decisively below 3% yesterday and continues to edge lower today. At 2.95%, it is the lowest since September 13 and is on its way to test the August 22 low near 2.81%. Odder still, the 2-, 3-, and 5-year portion of the US yield curve has inverted for the first time in over a decade.

An inverted US yield curve has been the market bogey-man this year. While falling short of the more widely-followed inversions (3-mo to 10-year, 1- to 10-year, 2- to 10-year), we think that this current inversion of a portion of the curve is clearly spooking investors as global equity markets are giving back their rent gains and then some.

This US yield compression comes despite the recovery in oil prices and still-firm US data. The November ISM manufacturing PMI came in at 59.3 and was much stronger than the expected 57.5. New orders rose to 62.1 and employment rose to 58.4. Stronger than expected November auto sales (17.4 mln annualized rate) were also reported yesterday.

There is a backdrop of perceived Fed dovishness. Chairman Powell and Vice Chairman Clarida have both made comments that seem to suggest that the Fed is nearing the end of the tightening cycle. It’s clear that the bond market is now running with this theme.

We continue to believe that this is an incorrect read. Economic conditions have not shifted that much over the past few weeks, as the US economy continues to grow above trend and the labor market is near full employment. US financial conditions (as measured by the Chicago Fed) are near record looseness despite the Fed’s eight rate hikes to date. A dovish message was not the right message to send to markets, in our view.

To repeat the obvious, Fed messaging could use some work. In what appears to be an attempt to make a subtle change to its forward guidance, the Fed has now unnerved markets with what we perceive to be unwarranted recession fears.

Market expectations for the December 19 FOMC meeting have been largely unaffected, with WIRP showing over 75% odds of a hike then. The adjustment has been seen further out as the implied yield on the January 2020 Fed Funds futures contract has been hovering around 2.70% since last week, the lowest since early September and down from a peak near 2.95% on November 8. This current implied yield suggests only one hike in 2019 after the widely expected hike this month.

 

 

There’s no doubt that the US yield curve has flattened significantly over the past couple of years. The 2- to 10-year spread is currently the lowest of the three spreads at around 20 bp, the lowest post-crisis level but still short of inversion. The 3-month to 10-year spread, which the San Francisco Fed has shown to be a better predictor (see Brief History Lesson below), is by comparison a whopping 65 bp and quite far from inverting. To us, the 2-, 3-, and 5-year inversion seems to be more of a quirk from the flat yield curve than a precursor of something more ominous.

 

A BRIEF HISTORY LESSON

Beginning in the late 1980s, economists began to run empirical studies on the predictive power of the inverted yield curve. There are too many theoretical explanations for its predictive power to delve into in this piece. What matters is that it works quite well.

From a San Francisco Fed study back in March: The predictive power of the term spread is immediately evident from Figure 1, which shows the term spread calculated as the difference between ten-year and one-year Treasury yields from January 1955 to February 2018, together with shaded areas for officially designated recessions. Every recession over this period was preceded by an inversion of the yield curve, that is, an episode with a negative term spread. A simple rule of thumb that predicts a recession within two years when the term spread is negative has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession. The delay between the term spread turning negative and the beginning of a recession has ranged between 6 and 24 months.

Another piece by the San Francisco Fed later suggests that the 3-month to 10-year spread has the strongest predictive power. Researchers wrote that “that the traditional 10y–3m spread is the most reliable predictor, and we do not find any evidence that would support discarding this long-standing benchmark as a measure of the shape of the yield curve. It is worth emphasizing again, however, that all of these term spreads are fairly accurate predictors and quite informative about future recession risk; the differences in forecasting accuracy are small.”

Is it different this time? Some optimists believe that yield curve inversion no longer provides a dependable signal of recession. St. Louis Fed President James Bullard recently wrote that “I recall similar comments relative to the yield curve inversions in the early 2000s and the mid-2000s—both of which were followed by recessions.”

Researchers at the San Francisco Fed write that “a number of observers have suggested that a low or even negative term spread may be less of a reason to worry than usual, arguing that historical experiences do not necessarily apply to the current situation. One factor that is different from before is that, despite some recent increases, the level of interest rates is low by historical comparison. The argument goes that increases in the short-term policy rate may slow down the economy less than usual in such an environment. Similarly, given the currently low level of the natural policy rate, a closely related argument suggests that low long-term rates do not necessarily reflect a pessimistic economic outlook but rather a new normal for interest rates.“

Those researchers at the San Francisco Fed concludes otherwise. “While the current environment appears unique compared with recent economic history, statistical evidence suggests that the signal in the term spread is not diminished. These findings indicate concerns about the scenario of an inverting yield curve. Any forecasts that include such a scenario as the most likely outcome carry the risk that an economic slowdown might follow soon thereafter.”

We agree. While we believe that the full curve will not invert (see Economic Outlook below), we cannot ignore the signal that such an inversion would give.

 

ECONOMIC OUTLOOK

The bond market rally and heightened recession fears come despite firm US data in Q4. In October, 250k jobs were created and consensus sees another 200k added in November. Average hourly earnings rose 3.1% y/y in October and are expected to remain at that cycle high in November. Auto sales were 17.4 mln annualized in November, down just a tick from the year’s high of 17.5 mln in October. ISM manufacturing PMI jumped to 59.3 from 57.7 in October and is just below the cycle high of 61.3 from August.

The Atlanta Fed’s GDPNow model is tracking 2.8% SAAR growth, up from 2.6% last week, while the NY Fed’s Nowcast model is tracking at 2.5% SAAR. Sequentially speaking, growth has slowed from the 4.2% SAAR peak in Q2 to 3.5% in Q3 and possibly sub-3% in Q4. However, growth remains above trend, widely recognized to be around 2%. Note that Bloomberg consensus shows US GDP growth remaining above 2% on a SAAR basis until Q1 2020 and above 2% on a y/y basis past Q1 2020.

Yet markets seem to be focusing on the recent easing of some inflation measures. Core PCE, the Fed’s preferred measure, fell to 1.8% y/y in October after spending several months at the Fed’s 2% target. Core CPI rose 2.1% y/y in October, down from the 2.4% peak in July. The US 5-year TIPS breakeven rate is currently around 1.78%, up from the 1.73% trough from late November but still quite low given headline CPI inflation of 2.5% y/y.

With the labor market so tight and likely to get tighter, we firmly believe that wage pressures will move higher. We think that reports of the death of the Phillips Curve have been greatly exaggerated (more on this in a future MarketView piece). This in turn will filter through to generalized price pressures. Also adding to this mix are ongoing tariffs, though the planned hike January 1 from 10% to 25% on $200 bln of Chinese goods has been delayed with the recent US-China trade truce.

 

INVESTMENT OUTLOOK

Bottom line: We downplay the significance of recent Fed messaging as well as the recent recession fears. Recent US economic data suggest markets are still underestimating the Fed’s capacity to tighten. While much depends on the US economic performance in 2019, we think US rates are likely to rise more than what markets are expecting. This is dollar-positive and equity-negative, to state the obvious.

Recall that while markets are intently focused on the 10-year yield, the Fed only sets short-term money market rates. With price pressures expected to move higher, we are not as concerned about the prospects of an inverted yield curve as others are. Instead, we look for an eventual parallel shift upwards in the yield curve as the Fed continues to hike, with risks tilted towards a bearish steepening if price pressures intensify as we expect.

Markets will be very interested in the December Dot Plots. Will they show any downward movement from the three hikes currently signaled for 2019?   Will there be another shift in the longer-term neutral rate? Looking at the dot clusters from September, it would not take much to move either of these down.

Michelle Bowman was recently confirmed as Governor, and so her contribution to the Dot Plots will be new and quite frankly unpredictable. She brings the total number of contributors up to 17. That group is made up of 5 members of the Board of Governors (Powell, Clarida, Quarles, Brainard, Bowman), 5 voting regional Fed Presidents (Williams, Bullard, Evans, George, Rosengren), 4 alternates (Harker, Kaplan, Kashkari, Mester), and 3 non-voters (Barkin, Bostic, Daly). Governor nominees Goodfriend and Liang still need to be confirmed by the Senate before all 19 contributors are fully represented in the Dot Plots.

Of course, this is all predicated on a continued economic expansion in the US. If the facts change and the economy slows or goes into recession, then the Fed will have no choice but to adjust its expected rate path. But for now, the economy can cope with and needs more tightening.

While being dollar-positive, a steeper US rate path than what markets are currently pricing in will be very, very negative for EM. This is especially true for the debtor/deficit countries like South Africa, Turkey, Brazil, India, and many more. On the flip side, the surplus/credit countries like Korea, Singapore, and Taiwan are likely to hold up relatively better.