Traders cling to the hope that an inverted yield curve this time around won’t lead to recession. (Reuters: Phil Hanna)
“Maybe it is different this time.”
These six words, when strung together, generally lead to misery and strife if applied to having a punt on financial markets.
However, despite legitimate reasons why markets should worry about “inverted bond yields” predicting a US recession, when global strategists of the ilk of Gerard Minack suggest “maybe it’s different this time” it’s worth pondering.
Minack Advisors principal Gerard Minack says investors shouldn’t necessarily make a recession their “base case”. (ABC News)
Mr Minack was a strategist for Wall St giant Morgan Stanley more than a decade ago when he took the lonely and contrarian view the US market was toast and about to be badly burnt by masses of poor quality debt.
He extrapolated that into the view that Wall Street and the ASX were primed to halve in value well before the GFC started breaking out in late 2007.
Peak-to-trough the S&P500 fell 56 per cent over the GFC while the ASX 200 dropped 53 per cent, so it was a pretty good call for clients who heeded his insight.
So while the media has attached the “uber bear” moniker to Mr Minack, he has a much deeper and original view of things than being spooked by every sell signal stalking Wall Street.
“While the yield curve has a terrific track record, I think this time it may be wrong,” said Mr Minack, who now runs his own Sydney-based, eponymously named firm, Minack Advisors.
“There are clearly risks to US growth, but I don’t think investors should make a recession their base case.”
What is an inverted yield curve anyway?
The normal state of affairs sees bond yields along the so-called yield curve — starting at one-month running through to 30-year debt — rising steadily, or sometimes sharply, compensating investors for the mounting risk of holding the bonds for longer.
Theoretically, a 30-year bond should deliver a much better return than a 10-year bond. That in turn should have a higher yield than a two-year maturity.
The recent 100-year bond sold by the Argentinian Government is a case in point — great yield, too bad investors are heavily underwater on the price right now and could lose the lot as the country is marching towards defaulting on its debts (again).
Yield curves can flatten, narrowing the gap between short and long term returns, in extreme cases they invert and long term yields are lower than short term.
In both cases, the expectation is similar — a weaker economy down the track. The flatter the curve the weaker the outcome. When it inverts, well, a recession is commonly around the corner.
However, it’s not an infallible signal.
Inverting before the previous seven US recessions is a pretty fair record.
However, the 1965 yield inversion fired a recessionary blank, as did the brief 1998 flirtation with flipping the curve.
“It’s worth noting that the yield curve is much less useful elsewhere; in Japan, for example, the two-year to 10-year spread has almost never inverted in the past 25 years, failing to warn of four recessions through that period,” Mr Minack points out.
Yield curve inversions have preceded the past seven US recessions (Source: Refinitiv Datastream)
It’s different this time
However, those aberrations are not the primary reasons why Mr Minack believes the bond market may not send the right signal this time.
“This yield inversion is very unusual,” he said. “It is the result of yields falling — the 30-year bond yield fell to an all-time low overnight — not the Fed tightening.”
In all but one case in the US, yields invert when short term rates rise faster than long term rates, as the bond market shadows the Federal Reserve in a rate raising cycle, but bets the Fed is raising too quickly.
In most cases the market is correct, the Fed had been too aggressive, choked off growth and delivered a recession.
Interestingly, the one other case of an inverted yield when the Fed was cutting was back in 1998 when the last false signal delivered.
Right at the moment, the action is happening at the long end of the curve; 10-year yields are falling faster than two-year yields.
Traders are betting the Fed hasn’t cut hard enough to head off looming problems. They are either positioning themselves for lower borrowing costs or, in the case of the so-called “bond vigilantes”, actively trying to force the Fed lower.
Bonds have decoupled
RBC’s US chief economist Tom Porcelli is even more dismissive of the interpretation of the message emanating out of the bond market this time around.
RBC chief US economist Tom Porcelli says bond yields have decoupled from growth and are no longer an accurate predictor of recessions. (Supplied: LinkedIn)
“The problem with using the inversion and the historical record is that the yield curve at present is not a referendum on the path of economic growth in the United States, but rather a function of goings on globally,” Mr Porcelli said.
“Historically it works as a good recession signal because the 10-year part of the curve theoretically reflects nominal growth prospects going forward.
“However, this cycle, yields have decoupled from growth in a very material way.”
Mr Porcelli has a point. Nominal GDP growth is churning along at a respectable 5 per cent, while 10-year bond yields have shrivelled to 1.6 per cent.
“Yields have become more a function of global growth dynamics and indeed have become anchored to low/negative sovereign yields abroad,” Mr Porcelli said.
“So, no, we are not on recession watch because of this dynamic.
“In fact, the fundamentals — especially on that 70 per cent slice of the US economy known as the household sector — continue to argue for a protracted expansion.”
Mr Minack agrees the US domestic economy is looking reasonably solid and there are few other signals flashing warnings.
Unusually, for periods of flatter yield curves, banks’ lending margins have not shrunk this time around — largely it appears because the Fed now pays interest on the $US1.6 trillion in reserves commercial banks have parked there.
“Historically, loan growth has slowed as the yield curve flattens. But with banks loosening lending standards there has been an acceleration in commercial and industrial lending,” Mr Minack said.
That in turn is supporting the US economy.
Running for the exits
So what about the sudden flight from risk and global dumping of equities? Mr Minack argues it may be overdone.
“If trade tensions ease — a contentious ‘if’, to be sure — and US growth remains reasonable then I do not think the curve inversion will mark the start of a bear market.”
Over at RBC, you sense Mr Porcelli’s frustration that the dreaded inverted yield has ever made it into the wider consciousness, of the public in general and his clients in particular.
“Investors keep coming back to the same fears with little regard for how the current dynamic of curve inversion is very different from historical episodes,” he said.
“That said, this does not discount the idea that we can talk ourselves into a slowdown. And merely this notion that the historical yield curve signal can impact so-called ‘expectations’ will keep the Fed engaged and very proactive in terms of fighting this inversion.”
In other words, expect the Fed to keep cutting rates, something that is generally not a precursor to recession. It generally occurs after the fact.