Talk of an inverted US yield curve flagging a recession is completely misplaced, says Robeco investor Lukas Daalder.
Fears have grown that a flattening in the curve that depicts the difference in yields between shorter-dated and longer-dated government bonds is a bad omen. “This has triggered a lot of concerns, with people claiming that this is a sign that US expansion is coming to an end,” says Daalder, Chief Investment Officer of Robeco Investment Solutions.
“People are worried mostly because since the mid-1970s, all recessions have been preceded by a period when the yield curve was inverted, meaning that the 10-year yield was lower than the 2-year yield. This correctly signaled five out of five recessions: neither economists (‘zero out of the last seven’) nor the stock markets (‘nine out of the past five’) can boast such a strong track record of predictions.”
“So although this does look like a reliable leading indicator, there are a number of reasons why we think the whole ‘a-recession-is-around-the-corner’ theme is overdone right now.”
Daalder says firstly, the notion that an inverted yield curve is an early warning system is not infallible, particularly if the bond durations used are changed, as shown in the chart below. “Things look somewhat different when we extend the timeframe, such as by switching from a 2-year Treasury yield to a 3-month interest rate,” he says.
“Here we now have two false signals: neither the inversion of 1966, nor that of 1998 were precursors of a recession. Not every inverted yield curve ‘leads’ to a recession, apparently. It is clear that the yield curve has not always acted as a reliable early warning system, and it can be questioned whether in this day and age of central bank intervention in bond markets, it still has the same predicative qualities that it used to have.”
So why does this fear persist, when the US is nowhere near an inverted yield curve using either 2-year bonds or 3-month rates at the short end? It stems from the Fed signaling that it expects to make three quarter-point rate hikes in 2018, which would bring policy rates above 2% for the first time since 2008, Daalder says.
“If you add the 75 basis points of rate rises to the 2-year yield while keeping the 10-year yield unchanged, voila! … you end up with an inverted yield curve,” he says. “If only things were that simple. There are a number of important assumptions being made here, all of which can be questioned.”
“First, in recent years we have seen that the Fed’s expectations are usually too optimistic when it comes to rate hikes. Not surprisingly, financial markets only expect rates to rise by 50 basis points, as can be deduced from the December 2018 Federal Funds Future.”
“Second, the link between the Federal Funds rate and 2-year yields is fuzzy at best. But by far the biggest – and the mostly unlikely – assumption however is that 10-year yields will remain unchanged during 2018. This would imply that the Treasury market will not be affected by the steady unwinding of the Fed’s bond holdings, along with other issues such as the Trump tax cuts and a tighter labor market.”
“In other words, the Fed would be raising rates as a result of an ongoing improvement in growth, but we are assuming here that bonds would not be impacted by that same underlying momentum improvement. This is a story that does not sound very plausible.”
Daalder says that even if the yield curve does eventually invert, this still does not mean that a recession is around the corner. “Historically, on average it has taken another 18 months before the recession started,” he says. Given the fact that stocks typically start their descent four months prior to a recession, it is clear that this is not a very reliable sell signal, at least for the time being.”
“Another misnomer is that the steepness of the yield curve is an indicator for the underlying strength of an economy. If this is indeed true, then it is clear why there is rising concern about the flatter yield curve: the flattening would signal an even lower growth rate than the one we have seen in recent years.”
“However, historically there has not been a clear-cut relationship between the two. Neither in the late 1980s, nor in the late 1990s, did the flattening of the yield curve coincide with a lower growth rate; instead, it coincided with a higher one. In fact, looking at growth and the yield curve during the current expansion phase, one might even claim that the relationship seems to have been inverse.”
The content displayed on this website is exclusively directed at qualified investors, as defined in the swiss collective investment schemes act of 23 june 2006 ("cisa") and its implementing ordinance, or at “independent asset managers” which meet additional requirements as set out below. Qualified investors are in particular regulated financial intermediaries such as banks, securities dealers, fund management companies and asset managers of collective investment schemes and central banks, regulated insurance companies, public entities and retirement benefits institutions with professional treasury or companies with professional treasury.
The contents, however, are not intended for non-qualified investors. By clicking "I agree" below, you confirm and acknowledge that you act in your capacity as qualified investor pursuant to CISA or as an “independent asset manager” who meets the additional requirements set out hereafter. In the event that you are an "independent asset manager" who meets all the requirements set out in Art. 3 para. 2 let. c) CISA in conjunction with Art. 3 CISO, by clicking "I Agree" below you confirm that you will use the content of this website only for those of your clients which are qualified investors pursuant to CISA.
Representative in Switzerland of the foreign funds registered with the Swiss Financial Market Supervisory Authority ("FINMA") for distribution in or from Switzerland to non-qualified investors is Robeco Switzerland AG, Josefstrasse 218, 8005 Zürich, and the paying agent is UBS Switzerland AG, Bahnhofstrasse 45, 8001 Zürich. Please consult www.finma.ch for a list of FINMA registered funds.
Neither information nor any opinion expressed on the website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. An investment in a Robeco/Robeco Switzerland AG product should only be made after reading the related legal documents such as management regulations, articles of association, prospectuses, key investor information documents and annual and semi-annual reports, which can be all be obtained free of charge at this website, at the registered seat of the representative in Switzerland, as well as at the Robeco/Robeco Switzerland AG offices in each country where Robeco has a presence. In respect of the funds distributed in Switzerland, the place of performance and jurisdiction is the registered office of the representative in Switzerland.
This website is not directed to any person in any jurisdiction where, by reason of that person's nationality, residence or otherwise, the publication or availability of this website is prohibited. Persons in respect of whom such prohibitions apply must not access this website.