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The US yield curve has now inverted, does this mean a US recession is on the horizon?

29 March 2019

There has been a lot of noise the past week about the US yield curve inversion. In practice, this means that investors in US government bonds are now being paid a higher level of interest to lend on a three-month basis rather than over ten years. This is an important development given a yield curve inversion has preceded the last nine US recessions. The time-lag between a recession and yield curve inversion has been 12-18 months on average, depending on which measure is used. So should we all heed the warning or is it different this time?

First, let's examine what this yield curve signal implies about the economy. If borrowing over the short-term is more expensive than over the longer term, investors and businesses who need to refinance or are reliant on short term funding will take a more cautious approach towards future investment. This in turn could reduce the growth potential of an economy and result in a potential contraction. Therefore, an inverted yield curve could have some significant ramifications for the real economy. Given these effects, and the aforementioned historic events, such a strong signal is difficult to ignore. There is however much debate about which yield curve signal holds the most weight. The closest watched curve is the difference between two year and ten year treasuries (2-10) , which has still not inverted and has proved to be a reliable indicator in the lead up to previous recessions. With two indicators signalling different things, should we ignore the indicators altogether?

Not necessarily, the actions of the US Federal Reserve (Fed) last week could offer some clues as to why we see this discrepancy. The Fed has been reducing its balance sheet since October 2017 by incrementally trimming the amount it will reinvest of maturing holdings. Last week, it announced that it would increase the reinvestments from May before stopping the balance sheet reduction exercise in its entirety in September. This timeline was ahead of most investor expectations and shows that the Fed will have a greater impact on treasury markets than previously thought. Taking a closer look at its balance sheet, we can see that its government bond holdings consist of nominal and inflation-indexed treasuries but it does not include any treasury bills. Two year treasuries will benefit from the large buyer supporting the market, whilst shorter dated bills will see no such support. This could explain why these two indicators are not aligned.

Investors who question the reliability of the indicator this time around may have valid reason to but it would be unwise to dismiss this signal altogether. Weak German manufacturing, ongoing trade disagreements between the US and China, and, Brexit jitters, may help explain the risk-off sentiment which has supported treasuries, but these could improve. On the other hand, global activity has slowed down and it is difficult to predict if central banks have done enough to boost growth and steer us comfortably away from a dreaded recession outcome. Based on the much-followed 2-10 curve, the Fed may have done enough at its last meeting to support consumers by lowering borrowing costs on mortgages. We will however continue to monitor incoming data carefully to verify that the amber signal of the yield curve inversion means vigilance rather than caution.      

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