GLC Insights - The inverted yield curve

An inverted yield curve, a pig that can fly, and the tail end of a bull market. Three big market themes happening right now, what to make of them and what to do next.

Part 1:  The inverted yield curve

It happened – the dreaded ‘inverted yield curve’. Late in March, financial media lit up with word the yield curve had ‘inverted’. Market pundits hit the air to issue dire warnings for days ahead. So, what’s the big deal?  

To view the full outlook report with all accompanying sections, tables and charts, please see the attached PDF reports at the bottom of this article. All data is current as of April 15, 2019.

If you wish, you can also listen to a podcast about this article:

Amin: Hello, I’m Amin Barakat, Vice-President at GLC Asset Management Group.  Welcome to the first of a series of three podcasts we will be bringing you on three big market themes happening right now, what to make of them and what to do next. The three themes are the inverted yield curve, the outlook for the US and Chinese economies and the anatomy of a bull market.

Before we get started, I want to mention that listeners can access all of GLC’s podcasts through our website or subscribe to the podcasts through Apple’s app, Google Play and Spotify by searching GLC Asset Management.  You will get new episodes automatically when they are released.

And now I would like to welcome our featured speaker for all three of our series of podcasts, with me is Brent Joyce GLC’s Chief Investment Strategist. Brent, we know that markets are always feeding on a steady diet of economic data and financial indicators. These days, the data that gets the most attention seems to center around a few particular developments I want to get your take on. 

1)  One particular development that got the financial press pretty riled up is the inversion of the yield curve. To clarify, can you explain what yield curve inversion refers to and why there would be a negative connotation associated with it?

Brent: Sure Amin, first let’s cover off some technical details and clarify some of the lingo around this subject.

For the yield curve, picture a graph where time is on the horizontal axis, this time period will range from 3 months all the way out to 30 years. The vertical axis is increasing amounts of yield, (or the interest rate, maybe more familiar to some) for a bond. In a normal environment, bonds of a longer maturity date pay more (i.e. offer a higher yield) than those of a shorter duration. That’s because holding debt, like owning a bond, for longer is riskier and therefore warrants a higher payoff to the lender for taking on more risk. So for example if a 2 year bond yields 2% and a 10 year bond yields 3% and a 30 year bond yields 3.5% you can draw a line between all those points and you would have an upward sloping line – this is your yield curve. When longer dated bonds pay a lower interest rate than shorter-term bonds, the plotted curve slopes downward – this is known as an ‘inverted yield curve’.  It’s worthwhile noting that the nearer term (or short-end) of the curve is highly influenced by central bank policy rates; the mid-section, often called the ‘belly’ of the curve, tends to be influenced by where investors expect the central bank overnight-interest rate to move next; and the long-end of the curve is largely influenced by inflation expectations and long-run real economic growth potential.  

You can plot a curve for any number of types of bonds, but the yield curve most commonly referenced is the ‘U.S. yield curve’, referring to the yields on various maturities of sovereign government bonds of the United States. Of course in the finance biz, there is always lingo, so we refer to yield curves by the pairs of the maturities being compared: so we would say the 30’s/10’s for difference in yield between a 30-year bond and a 10-year bond and the most common yield curves that are discussed are the 10’s/2’s, and 10’s/3month (or 90day yield). 

Amin: The yield curve inverted recently, is it significant, and why is there a negative connotation associated with it?

Brent: Well, North American yield curves have been on a steep downward trajectory for over two years, culminating in the 10’s/3month yield curve inverting on March 22, 2019. Notably, only the very front-end of the yield curve has inverted and the inversion was brief. However, this did mark the first inversion of this segment of the yield curve since July 2007, and you are right, much ink has been spilt discussing what this means for the future of the economy and stock markets.

The hype stems from a belief that when the yield curve inverts, it spells trouble for the stock market and the economy. While we don’t entirely dismiss signals from the bond market, we do take issue with people potentially over-reacting to this news. We wish to provide our investors with a better understanding of what is happening in the bond market and the full story around the history of past yield curve inversions.

Amin: OK, so what do you think are some things for investors to consider?

Brent: For starters there is little consensus among researchers and market experts as to which yield curve measure (i.e. the 10’s/2’s or 10’s/3month for example) is most predictive of future economic and stock market performance, and therefore a wide variety of yield curves are frequently measured and reported on. We look at both equally, one did invert and the other has not inverted at all.

Likewise, much is said about the duration and extent of the yield curve that has inverted relative to its ability to signal a forthcoming recession. In that regard, only a small portion (the very front-end) of the yield curve inverted on March 22nd and the inversion was short-lived, only lasting a few days. This suggests a weak predictive signal. A stronger, broader and longer yield curve inversion would give us much more to worry about. For the yield curve to initially invert, then re-steepen, is common. In fact, for the last three yield curve inversions, it has been the second occurrence of inversion that has been the more powerful signal that the economy and equity markets are set to materially weaken – this has not yet happened. 

Most notably, there has been varying lengths of time lag between the first instance of yield curve inversion and the eventual timing of any equity market or broader economic weakness. Looking at the past 5 yield curve inversions going back to 1978, on average it took 21 months between the first yield curve inversion and the onset of a recession. It took on average 16 ½ months between the first yield curve inversion and the eventual peak in the S&P 500, and during that time the S&P 500 gained an average of 24%.

Amin: Brent, I think investors might find some of those statistics quite surprising. In essence, it is possible for economic growth and positive market returns to continue for some time after the yield curve inverts.

As they say, the devil lies in the details. You’ve done a lot of research on past yield curve inversions and you’re not really concerned about this most recent one, at least for the time being. Can you explain why that’s case?

Brent: Sure. The inverting of the yield curve has historically come
at the hands of central bankers, where policy makers raising rates in an effort to prevent a robust economy from over-heating. The problem is that raising interest rates is a blunt tool and it has historically cooled off the economy too much, resulting in a recession. Now there are other factors at work that may have caused prior recessions or contributed to them, so we need to be careful not to confuse correlation with causation. Let’s look at where the evidence takes us.

What is similar about this period to past yield curve inversions is the Fed hiking interest rates and a growth slowdown are the key drivers of this yield curve inversion. The Fed has been raising interest rates for three years, lifting the overnight rate by a ¼%, 9 times. What finally tipped the scale was fears of a global growth slowdown that set off a decline in long-term bond yields, which in turn inverted a small portion of the yield curve just the 10’s/3month.

Ultimately, what a flat yield curve is really supposed to signal is a shut-down of credit flowing in the economy. Surveying a variety of other credit cycle indicators in the U.S., none are flashing a corroborating ‘recession’ signal. For example, loan officer surveys remain unchanged from the fall. Similarly, surveys of bank lending standards remain unchanged, and some  banks are reporting an easing of loan covenants and extending credit lines. Broad measures of credit, leverage and risk in the economy remain below historical recession levels.

Amin: There is another aspect to consider here. One can argue that bond yields in the post-financial crisis era have been influenced more substantially by unconventional monetary policy – specifically Quantitative Easing, like you mention. Does that play a role in how you look at the shape of the yield curve?

Brent: Yes, I think it is very central to interpreting any kind of signal this recent yield curve might be sending. There are striking differences this time, that didn’t exist in prior episodes of yield curve inversion.

Bond yields globally, and perhaps most especially the U.S. 10-year yield are experiencing artificial downward pressure from the extraordinary quantitative easing (QE) campaigns undertaken not only by the U.S. as I mentioned, but by European and Japanese central banks as well and these QE campaigns are ongoing, such that we see negative 10-year bond yields in Germany and Japan. These actions are distorting the global bond market. Absent this interference, we calculate that slope of the U.S. 10’s-2’s yield curve would currently be a full percentage point higher, and there would be no discussion of inverted yield curves at all.

Amin: Something we take for granted is that we are primarily focused here on the U.S. yield curve, not the Canadian one. As Canadian investors, why don’t we put more emphasis on our own yield curve?

Brent: The Canadian bond market is our area of focus, but the reality is. Like many things in Canada, the Canadian bond market is heavily influenced by our neighbours to the south. So the Canadian yield curve typically follows very closely the path of the U.S. yield curve. Of note, the Canadian 10’s/3-month yield curve also inverted late in March for a brief period, while the Canadian 10’s/2’s curve has not yet inverted – though both these Canadian yield curves are currently flatter than their U.S. counterparts. Also, in terms of historical signals, three of the last four inverted US yield curves came in the 70’s, 80’s and 90’s during those decades the Bank of Canada employed a monetary policy strategy that incorporated the exchange rate as one of its monetary policy instruments, and as such the Bank of Canada was prone to raising short-term rates to defend the currency. This distorted the Canadian yield curve, muddying the reliability of it as an economic signal.

Amin: Brent, from what you’re saying it sounds like while there’s validity in looking at the yield curve to get some signals about the state of the economy, it’s premature to draw conclusions based on this initial instance of the inversion at point in the cycle, and also when you take it together with some other broader economic indicators we’re seeing at the same time?

Brent: That is correct, Amin. We do not see this yield curve inversion as a signal to dramatically alter the orientation of a well-built balanced portfolio that is suited to one’s investment goals, time horizon and risk tolerance. Historically, over-reacting to this signal has come at a cost (a topic we will cover in greater detail in an upcoming podcast) and is not the advice we would recommend.

In the current environment, for all of the reasons we have laid out, the inverted yield curve that occurred late in March is not a flashing red signal for equity markets. It’s more of an amber light to investors on the road to long-term investment goals, saying ‘Proceed, but with caution’. 

For today’s market conditions and outlook, we don’t advocate that investors stretch to the edge of their risk-tolerance, nor do we think investors should be unduly pessimistic or overly defensive. We have been advocating a ‘neutral stance’ for long-term investment portfolios since June of 2018 and we continue to see a balance between equities and fixed income (in alignment with your risk tolerances) as most appropriate right now. Investors with shorter term time horizons (less than 3 – 5 years) and/or those who have specific capital requirements in the near-term (or recurring), should look to have those near-term needs allocated in cash, or cash equivalents.

Amin: Thanks Brent, I look forward to chatting with you in the second instalment of our series of podcasts covering the outlook for the US and Chinese economies.

An inverted yield curve (occurs when shorter-term bond yields rise higher than longer-term bond yields) has frequently been heralded as a predictive signal of an economic recession and stock market downturn (see Exhibit 1.1). History may rhyme, but it never repeats – there are two big differences in today’s market place we see as game changers:

  1. the cause of the overall low interest rate environment; and,
  2. the degree of credit still flowing within the economy and available to individuals and businesses.

As a result, we don’t interpret this development as a signal to dramatically alter a well-built balanced portfolio by overreacting to this signal.

In Parts 2 and 3 of this “Three Big Market Themes” series, we’ll dive into two other market themes that have us feeling better, not worse, about our outlook for equities.

The inverted yield curve that occurred late in March is not flashing a red signal for equity markets. It’s more of an amber light to investors on the road to long-term investment goals saying, ‘proceed, but with caution’.

For today’s market conditions and outlook, we don’t advocate that investors stretch to the edge of their risk-tolerance, nor do we think investors should be unduly pessimistic, or overly defensive. We have been advocating a ‘neutral stance’ for long-term investment portfolios since June of 2018 and continue to see a balance between equities and fixed income (in alignment with your risk tolerances) as most appropriate right now. Investors with shorter-term time horizons (less than three to five years) and/or those who have specific capital requirements in the near term (or recurring), should look to have those near-term needs allocated in cash, or cash equivalents.

North American yield curves have been on a steep downward trajectory for over two years, culminating in 10-year bond yields falling below 3-month bond yields on March 22, 2019, thereby inverting the yield curve. Notably, only a small portion of the yield curve has inverted, and the inversion was brief. However, this did mark the first inversion of this segment of the yield curve since July 2007, and much ink has been spilt discussing what this means for the future of the economy and stock markets.

We do believe yield curve inversions merit attention. They intuitively tell us something about economic growth expectations and, because they come at the hands of central bankers, the inversion of the yield curve can shed light on future central bank policy motives. But before jumping to dramatic conclusions about this one yield curve ‘signal’, let’s do some objective analysis of the situation at hand.

PRO TIPS - all about the yield curve

1.1 │Yield Curve Inversions and Recessions

Prior recessions have been preceded by yield curve inversions, then re-steepening, followed by a final rollover to deeper inversion.

Source: Bloomberg, April 15, 2019 Diagram compares U.S. 10-year and 2-year rates to show the four times since 1976 when the yield curve inverted in advance of recessionary periods.

Which yield curve, the duration, scope and steepness of a yield curve inversion all matter, and yet opinions on the same differ widely.

Specifically, there is little consensus among researchers and market experts as to which yield curve measure (the 10-year/2-year or 10-year/3-month for example) is most predictive of future economic and stock market  performance, and therefore a wide variety of yield curves are frequently measured and reported on. Exhibit 1.1 highlights the 10-year/2-year yield curve, which importantly has not yet inverted – the recent hype surrounds the 10-year/3month curve inversion only. Much is said about the duration and extent of a yield curve that has inverted relative to its ability to signal a forthcoming recession. We focus on all these factors and the extent to which the entire curve may or may not be inverted. Only a small portion (the very front-end) of the yield curve inverted on March 22 and it was short-lived. This suggests to us a weak predictive signal. A stronger, broader and longer yield-curve inversion would give us much more to worry about. Additionally, it’s common for the yield curve to initially invert and then re-steepen as we’re witnessing now. In fact, for the last three yield-curve inversions, the second occurrence of inversion has been the more powerful signal that the economy and equity markets are set to materially weaken – this has not yet happened.

We also know that historically, a curve inversion has coincided with a pattern of specific monetary policy actions. Yield curve inversions tend to happen as a result of central banks raising their overnight rate. The current experience is no exception as the U.S. Federal Reserve (Fed) has been raising interest rates for three years (lifting the Fed Funds Rate a quarter point, nine times). In this case, however, what finally tipped the scale was fears of a global growth slowdown. This set off a decline in long-term yields, which in turn inverted a small portion of the yield curve (the 10-year/3-month).

There are feedback loops at play here that drive responses from investors and central bankers.

  • Given the now lower-yield environment, investment theory suggests money should be biased to flow away from bonds toward equities.
  • All else being equal, lower yields support higher equity valuations (i.e., P/E multiples) and this tends to be positive for equity market performance.
  • Following inversion, the Fed pauses their rate hiking – a move that eases financial conditions, which in turn is supportive of economic growth and equities.

 

1.2 │Central Banks Have Killed the Term Premium

If the term premium was at its 20-year average, there would be no discussion of inverted yield curves and recessions.

Diagram shows the U.S. 10-year bond term premium rates and highlights the 20-year average of 1.0%. Bond term premium rates since 2016 are negative, which is definitely not normal.

 

We must also consider the extraordinary amount of manipulation that has occurred, and continues to occur, in global bond markets. Quantitative easing by many central banks is having an impact on the global yield environment (i.e., artificially keeping rates lower than normal market factors would otherwise imply) and this has ramifications that are relevant to the yield curve inversion discussion. Consider what is the same about the current episode versus what is different from past yield curve inversions:

Same:

  • The Fed hiking rates and a growth slowdown are the key drivers of this yield curve inversion.
  • The Fed has signaled a halt to rate hikes and plans to curtail its other monetary-tightening strategies.

Different:

  • The U.S. 10-year yield is experiencing artificial downward pressure from the extraordinary quantitative easing (QE) campaigns undertaken by the U.S., European and Japanese central banks that are distorting the global bond market. These QE campaigns are ongoing, such that we see negative 10-year bond yields in Germany and Japan.
  • One sign of central bank distortion may be the disappearance of the term premium (see Exhibit 1.2). Absent this interference, if the term premium were back toward itsaverage level of the past 20 years (~1%), the slope of the U.S. 10s/2s yield curve would currently be a full percentage point higher, and there would be no discussion of inverted yield curves.
  • Credit flows have not dried up. Ultimately, what a flat yield curve is supposed to signal is a shutdown of credit flowing in the economy. Surveying a variety of other credit cycle indicators in the U.S., none are flashing a ‘recession’ signal. For example, loan officer surveys remain unchanged from the fall. Similarly, surveys of bank lending standards remain unchanged, and some banks are reporting an easing of loan covenants and extending credit lines. Broad measures of credit, leverage and risk in the economy remain below levels historically associated with recessions (see Exhibit 1.3).

 

1.3 │U.S. Credit Conditions Not Signalling Recession

Prior recessions have been preceded by credit conditions that are much worse than today’s levels.

Source: Bloomberg, April 15, 2019
Diagram shows U.S. Fed financial condition indices, marking five times since 1976 when high levels above zero warned of recessionary periods that followed. Current rates are below zero, when financial conditions are considered easier.

 

We’re also watching trade negotiations, geopolitics and Chinese and U.S. economic growth as indicators of whether this bull market still has life (more on this in Part 2 of our ‘Three Big Market Themes’ series).

Using any one market signal (including an inverted yield curve) as reason to try and time the markets is not advised. Market-timing requires getting two decisions right – when to get out and when to get back in (in Part Three of our ‘Three Big Market Themes’ series, we’ll argue why you won’t want to get out right now). Empirical evidence suggests that investor emotions (greed and fear) are far too powerful for market timing strategies to be fruitful.

Bottom line  

The brevity and weakness of the yield curve inversion, along with more optimistic outlooks for China and the U.S., give us reason to believe that the inverted yield curve is more a symptom of current central bank policy and less a harbinger of an imminent recession.

Putting views into action  

Take a neutral position across both equities and fixed income (in proportions that align with your risk tolerance and time horizons). This will allow you to appropriately take into account both the opportunities and the risks that the current market backdrop presents.

PRO TIPS: All about the yield curve

The yield curve is the plotted measurement of bond yields across different maturities of bonds (with time plotted on the x-axis and interest rates plotted on the y-axis). You can plot a curve for any number of types of bonds, but the yield curve most commonly referenced is the ‘U.S. yield curve’, referring to the yields on various maturities of sovereign government bonds of the United States.

What is a term premium? It’s the difference between the yield an investor is willing to accept to own a single long-term bond versus the yield they believe they would achieve by rolling over short-term instruments for the same amount of time. The term premium reflects the buffer that investors need to account for two key risks: The first is a change in bond values through time due to changes in the supply and demand for bonds; and, the other is changes in the rate of inflation through time. When investors feel more uncertain on either point, they demand a higher premium.

The ‘slope’ of the yield curve refers to the angle of the line drawn between the yield at two different maturity points along the yield curve. It’s this yield curve slope that has historically been interpreted as a signal about future economic growth; a positive slope suggests future economic growth and a flat or negative (inverted) slope suggests economic weakness, or contraction is on the way.In ‘normal’ economic conditions, bonds of a longer duration pay more (i.e., offer a higher yield) than those of a shorter duration. That’s because holding debt, like owning a bond, for longer is riskier and therefore warrants a higher payoff to the lender for taking on more risk. When longer-dated bonds pay a lower interest rate than shorter-term bonds, the plotted curve slopes downward – known as an ‘inverted yield curve’. This happens when there is a disproportionate rise in shorter duration yields and/or longer bond yields fall. It’s worthwhile noting that the nearer term (or short-end) of the curve is highly influenced by central bank policy rates; the mid-section, often called the ‘belly’ of the curve, “tends to be influenced by where investors expect the central bank overnight-interest rate to move next; and the long-end of the curve is largely influenced by inflation expectations and long-run real economic growth potential.

The lingo: You can measure the difference in yield between any two bond maturities, but themost often talked about yield curves are the 30s/10s, 10s/2s, 5s/2s and 10s/3-month. The nomenclature is read as ‘the thirties, tens’ curve and refers to the difference between 30-year yields and 10-year yields, whereas ‘the tens, three-month’ is 10-year yield minus the 3-month yield.

Copyright 2019 GLC. You may not reproduce, distribute, or otherwise use any of this article without the prior written consent of GLC Asset Management Group Ltd. (GLC).

This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.