The curve that tells us when recession will hit

29 June 2018

When bond markets don’t return more to long-term investors, we need to pay attention, says Mark Rider.

img-thunderstorm-spotlight-hero.jpg The flattening of the yield curve usually indicates a recessionary storm is on the way Photo: mattabbe

Investors usually expect better returns from long-term bonds than short ones – it’s when that difference disappears that we’re most likely heading to recession.

The difference in returns between long and short-term bonds or debt securities is known as the yield curve. When economies are healthy that curve is upward and long-term bonds deliver greater returns.

When that curve flattens or actually inverts (meaning investors get more from short-term bonds) then we’re heading for trouble.

The yield curve is seen by many to be the most reliable predictor of the economic outlook. When we look at US economic downturns over the past 40 years, every time the yield curve has inverted the economy has ultimately gone into recession.

But it’s more than just whether the yield curve is inverted. The yield curve’s accuracy is quite amazing: the degree of steepness of the curve correlates (with a lead of around 18 months) with the pace of growth, so a flatter curve indicates slower growth and a steeper curve means a faster pace. Not surprisingly it also closely correlates with earnings on the US sharemarket.

10 year and 2 year US Treasury yield spread 2009-2018

Data source: YCharts/Federal Reserve (June 22, 2009 to June 22, 2018)

How we respond to inflation will make all the difference

Given the flattening of the yield curve recently, there’s increasing concern over central banks’ moves to cut economic support measures, which investors fear will cause further flattening of the curve meaning we’ll have recession sooner.

But it appears the US central bank is set to continue to increase interest rates, having indicated it is likely to do so several more times this year.

The US Federal Reserve cut the federal funds rate to nearly 0 per cent to stimulate the nation’s economy out of the global financial crisis. It didn’t start increasing rates until about eight years after, with the first one coming in 2015, and five more after that. The Fed is bringing interest rates back to normal to try and stop inflation rising too quickly. It is particularly concerned that low unemployment in the US will starting pushing up wages, giving people more money, so they spend more, and prices, hence inflation, rise.

Should the US Fed increase interest rates?

The yield curve is already suggesting the US economy will slow to around a 1.5 per cent pace by mid next year, and along with it earnings growth will stall.

It’s worth asking the question ’Does the Fed really have to raise short-term rates much more?’. This should be expected only if inflation looks likely to be well clear of 2 per cent (the Fed’s target), and therefore sees a need to slow the economy significantly. There’s no need to do it otherwise. (Recent US company tax cuts complicate things by providing a boost to the economy.)

What’s happening in the economy and markets now is consistent with ANZ Chief Investment Office’s prediction for 2018 that the ‘good times would fade’ as the investment cycle gradually comes to an end.

Right now, indicators – from the yield curve to ANZ’s investment cycle clock – point to a sharemarket peak in mid-2019. But we still need more flattening and inversion of the curve before a significant downturn is flagged. And Fed rate rises may make that happen.