The Canadian yield curve was briefly inverted out to five years on Tuesday before recovering to roughly flat levels. This is bad news for domestic investors. Just how bad things will get depends on how much faith remains in central bank monetary policy and the extent to which "it's different this time."
Supported by Federal Reserve research studies, inverted yield curves are a widely accepted, long-standing indicator of economic recessions. In Canada, the last time the yield curve was inverted out to five years (the five-year Government of Canada bond yielded less than the three-month T-bill yield) was in January, 2015, just as the domestic technical recession began.
The signalling value of the yield curve is a function of economic growth expectations and credit creation. In simple terms, the yield on longer-term bonds implies the consensus view on future economic growth and inflation. When the yield curve flattens, slower growth and inflation pressure is expected. For banks, a flatter yield curve means lending activity is less profitable.
The interest received on loans is low relative to the cost of raising short-term funds.
As for the yield curve's predictive ability for Canadian markets, the news isn't great, but somewhat open to interpretation in recent years. The accompanying chart tracks the forward 18-month returns for the S&P/TSX composite against the steepness (or flatness) of the yield curve between three month T-bills and five-year Government of Canada bonds.
From 1997 to early 2009, the yield curve provided a highly effective leading indicator for S&P/TSX performance (reminder – the TSX forward return is plotted; when the lines move roughly in tandem, it means the yield curve predicted the future course of equity market returns).
The results were more mixed after that point. From early 2009 until mid-2011, it looks more like equity markets predicted the yield curve as central banks raced to cut rates to support an economic recovery. The two lines moved back roughly together in late 2013, indicating that the yield curve was once again helping investors predict future equity returns.
The key question is whether the yield curve will remain an effective indicator for the S&P/TSX composite. Investors will hope it fails – the current flat curve suggests poor, or possibly negative, returns ahead. But the slow growth suggested by current bond prices fits well with reduced expectations for the domestic economy. Bank of Montreal senior economist Sal Guatieri cut his 2016 Canadian gross domestic product growth forecast on Friday to 1.0 per cent from 1.6 per cent, citing the likelihood of further commodity-related job losses.
"November's bounce in GDP could not fully offset previous weakness," Mr. Guatieri wrote. "While the services-producing sector (including retail) expanded in 2015, most of the goods-producing industries (including manufacturing) contracted. Most upsetting is that, despite record auto sales on both sides of the border, auto production actually declined, a victim of the lack of capacity-enhancing investment in recent years."
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