Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank’s main bond fund.
Market analysts have used the yield curve to discern the economic reality for a long time. This makes sense: Interest rates are essentially the cost of money discounted for time and risk.
Curiously, calling for a recession every time there is a minor inversion of any part of the yield curve has become almost a consensus view of late. Many market participants seemed to be programmed to robotically call for recessions every time the yield on a shorter maturity Treasury is a couple of hundredths of a percentage point above another government bond with a longer term to maturity.
It was not always that way.
I know this because I was very concerned about the economy before the financial crisis in 2008, which was the last real recession that we had. The 10-year to two-year spread of U.S. Treasuries was slightly inverted and rates, in general, were high relative to the inflationary outlook. That combined with other factors, like structured notes that were clearly overpriced relative to credit risk, and the absolute explosion in high-yield debt spreads, caused me to be cautious. However, my concerns were met with complete disdain by my partners at the firm I worked at and by most other mainstream market players.
But now, given that so many people believe in the yield curve inversion hypothesis, we should start to question its forecasting effectiveness.
Looking at past data, it is clear that from the 1950s to the present, the inversion of the yield curve has preceded most recessions. The logic is this: Recessions begin when central banks – the U.S. Federal Reserve in particular – raise rates too aggressively in the short end of the yield curve. Traders and portfolio managers realize that these rate levels are unsustainable so they bid up the prices of longer securities, which causes yields of longer bonds to decline to below that of money-market instruments. (Bond prices and yields move inversely.)
However, a technical inversion does not predict the severity of the downturn. The recessions in 1990 and in 2000 were preceded by sharper inversions than in 2008, which dwarfed the previous two downturns in severity.
Given that the 10-to-two-year spread is technically inverted now, and despite the insistence of the U.S. government that the economy is in great shape, we can call the present situation another win for the inverted curve hypothesis since the U.S. is in a technical recession, as defined by two consecutive quarters of GDP decline. Perhaps more importantly, real incomes are declining.
Unlike previous downturns, there are some circumstances that do make this time different. Rates, especially short rates, are nowhere near the levels of current inflation. Typically, the Fed raises rates above inflation and the economy weakens. Even if inflation drops from its current 8.5 per cent, at a two-year long yield of less than 3.5 per cent, monetary policy is still very loose by historical norms.
By my reading, the current yield curve is telling us that the market, in aggregate, expects a quick and sharp fall in inflation and everything will be fine. In other words, the yield curve may be technically inverted but rates are very low relative to price pressures, unlike previous downturns.
A couple of factors seem to support this.
The labour markets are very tight: Although unemployment is a lagging indicator, there is a worker shortage at the moment.
Meanwhile, in the past, the inversion of the yield curve before a recession almost always coincided with an upside explosion in spreads between high-yield corporate bonds (so-called junk bonds) and government issues. This is not happening now.
Why is the market so complacent about this kind of credit risk? Either market players do not believe that we are going into an economic period weak enough to harm the balance sheets of large publicly traded companies or they believe the government will bail out borrowers. This is not an irrational assumption. The student loan debt forgiveness program demonstrates a willingness on the part of the U.S. government to bail out almost anyone deemed friendly to the Biden administration. Corporate bailouts are expected and assumed. It makes sense that spreads are low if one assumes the “too big to fail” argument.
The bond market may be right, but given the manipulation by central banks of interest rates over at least the past 15 years, setting rates artificially low, we should not be certain that the curve is overly predictive of a recession.
The yield curve hypothesis has, once again, preceded a downturn. But it does not appear to offer us any insight into the magnitude of the downturn or its length. Given that rates are far below inflation and high yield bond to government issue spreads are not widening to levels of previous economic downturns, the curve seems to be saying that the recession will be very mild, very short and that inflation will soon be below 2 per cent.
I doubt if this optimistic forecast will be proven correct. It’s difficult to believe that inflation will so easily be crushed. Unlike weaker periods in the past, we are entering this one after a prolonged period of artificially low rates, a work force that is much older than in the past and unprecedented corporate, consumer and government debts.
Investors should be cautious. Hope for the best but prepare for the worst.
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