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Yield Curve's Recession Signal Leaves Some Investors Unswayed

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 Michael Flippo | Dreamstime.com

Tuesday, 26 March 2019 03:59 PM

The inversion of the U.S. yield curve has unleashed exasperation among some investors who say the recession indicator is shot.

The three-month to 10-year curve has reliably inverted before a downturn. That’s because weakening expectations for growth and inflation raise demand for long-term securities, driving their yields below those on shorter maturities.

While the flattening curve has stirred talk of recession for the past couple of years, skeptics warn that its signal is jammed. Their view is that central-bank policy has kept yields artificially low since the crisis, while negative rates in Europe and Japan stoke demand for U.S. assets.

For the doubters, the case for an impending recession lacks context, and their supporting evidence falls into three categories. Jim Caron at Morgan Stanley Investment Management needs more-ominous signs from U.S. economic data. Goldman Sachs Group Inc. strategists are among those looking for more deterioration in risk assets. Seema Shah, senior global investment strategist at Principal Global Investors, is focused on the depth and breadth of inversion.

“For us, there’s nothing which is suggesting there’s a recession on the horizon,” said Shah. “We look at yield-curve inversion as a recession indicator, but given the central-bank purchases over the past decade, you almost need to have a much deeper inversion before it starts to signal recession.”

The 10-year yield is about 3 basis points below the three-month rate. It inverted Friday for the first time since 2007 after the Federal Reserve unexpectedly revised its projections to reflect no rate hikes this year.

Data Mining

Some are dubious about the focus on this particular inversion. Greg Staples, co-head of Americas fixed income at asset manager DWS, said the three-month to 10-year signal “seems to be data-mined because that is the one pair that is inverted, but if you look at the rest of the curve, to a large degree it’s steep.”

The five- to 30-year, at 67 basis points, is close to its steepest since 2017. Goldman researchers Alessio Rizzi and Christian Mueller-Glissmann point out that the extent of inversion is still “quite weak compared to the last four recessions where more than 70 percent of the curve was inverted.”

The 2- to 10-year spread is also still positive, at about 15 basis points. For Caron at MSIM, a gap of negative 20-25 basis points on this segment would be a plausible recession signal, not just a simple inversion.

Goldman also would look for more deterioration in risk markets. Their research note this week pointed out that credit spreads, “which usually react to recession risk early,” haven’t widened materially.

Credit Check

Spreads on lower-tier investment grade bonds are around 154 basis points over the risk-free rate, down from almost 200 basis points at the start of the year, according to Bloomberg Barclays index data. The gap exceeded 300 basis points in the first few months of the last recession, eventually peaking above 700.

That broader weakening could show up a little more clearly soon, according to Caron at MSIM, if next month’s earnings season disappoints equities and credit investors. But he’s focused on the U.S. economic backdrop, which he doesn’t see as consistent with a slide toward recession.

Growth is still tracking at about 2 percent annual expansion as of last quarter, with inflation around target. He’s also watching jobs data, which show unemployment hovering around a 50-year low.

Mistaken Narrative

And while the curve’s recession signal is in doubt for some, others see it as an actual distraction. Tom Porcelli, chief U.S. economist at RBC Capital Markets, put it plainly in a note this week entitled “The knee-jerk yield curve narrative is wrong.”

Alongside the argument that low rates overseas have anchored U.S. 10-year yields, he noted that another key ingredient is missing to put this current inversion on a par with prior, accurate recession signals. That is, the Fed needs to have plausibly overtightened. As it stands, the Fed has paused this cycle before even reaching a neutral policy rate.

“The inversions that did lead to downturns lined up with a fed funds well north of neutral,” Porcelli wrote.

That’s significant for Porcelli, as he sees the U.S. expansion benefiting from artificially low rates, which have also in the past spurred asset-price inflation.

“So, no, we are not on recession watch because of this dynamic,” he wrote. “We are, more than any other point this cycle, on bubble watch.”

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The inversion of the U.S. yield curve has unleashed exasperation among some investors who say the recession indicator is shot.
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Tuesday, 26 March 2019 03:59 PM
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