Yield curve inversion - (no) panic over the signals

Wednesday, 27th March 2019 15:46 - by Shant

Over recent months, and heightening in the past week or so has been the flattening and eventual inversion of the US Treasury yield curve, which in the past has been a 'reliable' indicator of a recession - or a slowdown at the very least.  Bond markets have tended to be a better indicator of the economic path ahead, and this should not be too difficult to appreciate when living in a credit-driven world.

As such, the capitulation in yields based on the turnaround in Fed policy communication has been dramatic in US Treasuries, drawing criticism on the world's leading central bank.  I would argue that the mistakes were made in the latter part of 2018 and that this year's retraction has been an unavoidable change in direction, largely precipitated by the heavy sell-off in financial markets at the end of last year.  The Fed tightened for a fourth time at a time when stocks were already showing unease - recall the initial reaction when the 10yr Note hit 3.25% - and a pause at that point would have perhaps not only saved some of the volatility seen last year but also allowed them a more balanced approach (from the Fed)  in the early part of 2019. 

So in effect, we can attribute a large chunk of the yield curve inversion (in my view) to the erratic communication process by the Fed.  Market overexcitement has also played a part.  In essence, the bond (interest rate) markets move to the tune of the underlying economic fundamentals, and there is a danger that some may view the gradient of the curve as a solitary focal point for risk sentiment rather than looking at worldwide dynamics.  

As I have written for a number of weeks now, the global economy is - and I believe - will continue to suffer from a degree of slowing demand.  Emerging markets and export-driven economies will suffer in this climate and as we have seen from the Eurozone data of late, there are clear concerns that what was seen as a blip in growth, could develop into something more sinister.  Looking at the economic malaise in Japan over the recent decades, it is clear that we have precedent and it is hard to believe that the Fed and the ECB will not have considered the limited impact of unconventional monetary policy measures, as the BoJ continues to power ahead with its asset purchasing program, ballooning its balance sheet in the process. 

This has more worrying consequences for Europe where the ECB has failed to tighten policy at a time when the economy was performing well - ie, through 2017 and early 2018 - with the added backdrop of a limited pool of bonds to buy due to its strict observance of the capital key.  

The Fed, however, does have monetary resources (ammunition) at hand and has already communicated its intent in cutting the reinvestment caps in May, phasing them out completely by September.  Fed funds now stand at 2.50%, and as many Fed members have communicated through the tightening cycle, a key rationale for this has been to build an economic buffer when the slowdown begins to bite.  Consequently, the longer end of the curve has priced this in rather swiftly as is a key feature of impulsive markets as mentioned above.   While the 'signals' cannot be ignored, fears of an imminent recession in the US are perhaps being overstretched at the present time, with other indicators such as default rates still relatively lower than at the stress points in previous late stages of business cycles.  

While I have been advocating a defensive approach to portfolio construction over weeks and months, the idea that a wholesale rout in global stocks is just around the corner can be tempered to some degree, though I see this largely through a period of extended sectoral rotation.  Once again I will stress the importance of staples, (pharma, foods, utilities), but long-short strategies will offer improved returns in this environment.  The essential point here is that yield curve inversion does raise a red flag, but perhaps not all out panic - yet! 

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.