Does the Yield Curve Inversion mean Recession? Is it time for a reality check?
By: M. Brent Wertz, Managing Partner
Does the yield curve inversion signal that the economy is headed for recession? This time may be different than past cycles when the yield curve has inverted. There is global interest rate arbitrage that is occurring which is certainly driving rates lower. There are increasing headwinds such as the trade war and tightening financial conditions that could lead to recession, however, let’s examine if a recession is imminent.
Over the past six to twelve months, several economists have had a very bearish forecast for global growth. It has led to government bond yields falling and yield curves flattening, but the recent rally in government bond markets has surpassed many investors’ expectations. The US yield curve is now partially inverted and, unsurprisingly, recession indicators derived from the yield curve are now pointing to the highest probability of a US recession since the global financial crisis. Meanwhile, German government bond yields are now negative across the curve.
At first sight, the gloom in the bond market is easy to justify. The German industry is in recession, Asian exports are contracting, and the US ISM manufacturing index is approaching a three-year low. However, our firm does not agree with the widespread view that the escalating trade war between the US and China poses a major threat to growth in both countries, but it clearly doesn’t help business confidence. Finally, there appears to be an increasing probability of a “no deal” Brexit.
However, it is important to retain some perspective, especially in thin summer trading. For every piece of negative data, it is possible to find a positive release. German industrial production fell in June, but industrial orders for the same month were strong. Chinese exporters are struggling, but the China Activity Proxy suggests that there is strength elsewhere, most notably in property construction, which has helped to shore up growth. Growth in Japan was surprisingly strong in Q2. And at a global level, while investment and jobs growth have weakened, capex and hiring intentions have stabilized.
Accordingly, while there are pockets of extreme weakness in the world economy, such as in manufacturing, other parts of the economy are holding up relatively well. All of this is consistent with our view that global growth is slowing rather than collapsing. However, there are several uncertainties worth monitoring. There are three downside risks worth watching over the coming months. The first is that the indirect effects of the trade war turn out to be larger than anticipated. In the short-term at least, most of the economic damage from the tariffs is likely to stem from the indirect effects on things like business confidence and investment rather than the direct effects on trade flows. These indirect effects are difficult to measure and can extend beyond the countries imposing tariffs on one another. A sharp drop in business investment over the coming months would be a sign that the costs of the trade war may be larger than anticipated.
The second downside risk to monitor is that financial conditions tighten. As this happens, the market turbulence of the past couple of weeks has not led to a significant tightening of financial conditions in major economies. (See Chart 1.)
Chart 1: Capital Economics Advanced Economy Financial Conditions Indicator (Standard Deviations)
Source: Capital Economics
But that is mainly because investors have responded to the gathering gloom by pricing in ever larger amounts of monetary stimulus. This raises the risk that the scale of central bank loosening falls short of market expectations, causing financial conditions to tighten and exacerbating the downturn to the real economy. Finally, it’s worth keeping an eye on developments in the service sector. While the manufacturing sector is in recession, the service sector has remained relatively resilient. The gap between the manufacturing and services PMI is now at a five-year high and it’s unusual for a divergence between the surveys to persist for long. (See Chart 2.)
Chart 2: Advanced Economy Manufacturing & Services PMI
Source: Capital Economics, Refinitiv, Markit
In 2004-05, the gap was closed by a rebound in manufacturing. But in 2012-13, it was closed by a drop in the services index. The extent to which the services sector can remain insulated from the current troubles in manufacturing will be a key factor shaping the outlook for the next six months.
How to manage the portfolio through this volatility?
This certainly appears to be reminiscent of the soft patch that the economy experienced in 2015-16 when oil prices plummeted. The manufacturing sector seems to be going through a similar patch but has been exasperated by the uncertainty of the trade talks. This uncertainty coupled with the global interest rate arbitrage impacts on yields has caused tremendous volatility in the markets. The most prudent course of action with your portfolio is to become defensive in credit risk and strategically extend duration. If we believe credit conditions will tighten, then a shift from lower credits to higher credits is appropriate. Similarly, if we believe rates are moving lower, we must strategically extend duration in the portfolio. Avoid rushing to add duration to the portfolio simply because rates are falling, rather gradually extend portfolio duration to either neutral or slightly long of the portfolio benchmark. Strategically extend duration with seasoned mortgages that have predictable cash flows and utilize fixed income securities that have good structure with very little optionality. It pays to be patient in this environment and avoid panic when the news is causing the markets to have volatile movements.
Sources: Capital Economics, Refinitiv, Markit