What is the US Yield Curve Telling Us?

The US yield curve has turned positive again. Did we dodge a bullet? Markets are likely to remain on US recession watch, but we look at past curve inversions to conclude that we may avoid recession in 2020. Other clues support this view, at least for now.

RECENT DEVELOPMENTS

Global tail risks for the US economy have fallen recently. The partial US-China trade deal has yet to be hammered out in full, but at least the risks of further escalation have eased. Elsewhere, the risks of a hard Brexit have fallen. While a final deal remains elusive due to the contentious Irish Backstop, we believe enough progress and goodwill has been seen to warrant an extension beyond October 31.

We believe these recent global developments take some pressure off the Fed to ease this month. These are the tail risks that have bothered the Fed and they appear to be slimming. As a result, the US 3-month to 10-year curve is now at +9 bp (after trading as high as +14 bp earlier today, the highest since April 23).  If sustained, this move back to positive slope will significantly push down perceived recession risk.

The US 3-month to 10-year curve first inverted in late May and stayed inverted until mid-October. The San Francisco Fed has shown this curve to be the best predictor of recession in the US (see Brief History Lesson below).

Does the nearly five-month long curve inversion signal recession ahead? Let’s look at previous historical examples. We only have US spread data going back to 1962, and so we cannot include the 1957 or 1960 recessions in our sample group. That still leaves us the remaining seven US recessions since 1955. We can also include the slowdown of 1967, which generated the only false positive by an inverted yield curve (see Brief History Lesson below).

Source: Bloomberg

This year’s bout of inversion closely resembles the 1966-67 inversion. Recall that inversion was followed by a slowdown but no recession. We are hopeful that the US curve will remain positively sloped going forward and believe that the relatively brief inversion will only lead to a slowdown and not a recession. Yet all yield curve inversions are not created equal. Much will depend on external factors, including a continued trade truce between the US and China.

Source: Bloomberg

 

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 2018: 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.

 

Source: Federal Reserve Bank of San Francisco

 

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 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 wrote 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 conclude 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 and so we are happy to see our long-held conviction that the curve would move back to positive slop.

 

ECONOMIC OUTLOOK

US data have undeniably softened in September. Weakness in the manufacturing sector appears to have spread to the wider economy. ISM PMI, jobs, CPI, PPI, and now retail sales have all come in weaker than expected. So too have inflation expectations. These developments would seem to argue for another cut. WIRP suggests 86% odds of a cut October 30. Because of the conflicting drivers, we put the odds closer to 50-50. Basically, a coin flip. And if it does cut, we think it will stay on hold after than until signs of a deeper slowdown emerge.

The Chicago Fed National Activity Index remains the best indicator of US recession risk and it came in better than expected at 0.10 for August.  Even though July was revised down to -0.41, the 3-month moving average still fell to -0.06 from -0.14 in July, the lowest since January.  Note that a value of zero shows an economy growing at trend.  Positive values represent above trend growth, while negative values represent below trend growth.  For now, the US is moving further away from recession and market expectations must be adjusted significantly. September CFNAI will be reported October 28.

Source: Bloomberg

We have one last thought on today’s retail sales data. Yes, the m/m readings don’t look so good, but the y/y readings tell a better story. Headline sales rose 4.1% y/y, down slightly from this year’s peak of 4.4% in August. Ex-autos rose 3.7% y/y, steady from August and the highest since April. Lastly, the control group rose 4.8% y/y, down slightly from this year’s peak of 5.2% in August. Bottom line: consumption is still growing solidly.

Source: Bloomberg

Indeed, we believe the US economic outlook remains solid.  The Atlanta Fed’s GDPNow model is now tracking 1.8% SAAR growth in Q3 vs. 1.7% previously, which is still near trend (~2%) with some drop-off from 2.0% in Q2.  Elsewhere, the NY Fed’s Nowcast model is tracking 2.0% SAAR growth in Q3 while its forecast for Q4 growth is tracking 1.3% SAAR, both steady from the previous week. This is updated weekly on Fridays.

The NY Fed has a recession probability model that’s based on the US yield curve.  It is updated monthly and the latest reading for September fell back to 34.80% from the high of 37.93% in August.  That was the highest since March 2008 and so the subsequent drop is welcome.  Curve inversion has averaged -5 bp so far in October but should move into positive territory if the current trend is sustained.  If so, this would lead to a significant reduction in recession probability for this month.

 

INVESTMENT OUTLOOK

Bottom line: We tend to downplay US recession fears for the time being. Some of the recent high frequency US economic data have weakened, but our favorite indicator CFNAI says otherwise. We believe that markets are still overestimating the downside risks. While much depends on the US economic performance in H2 2019 and H1 2020, we think continued solid economic growth means US rates are unlikely to fall as much as markets are expecting. This is dollar-positive and equity-positive. On the other hand, it suggests limited upside potential for US bond prices.

Of course, this is all predicated on a continued economic expansion in the US. If the facts change and the economy slows sharply 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 steady rates.