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Graph of the week

Graph of the week

07-12-2017 | Einblicke

The ‘R’ word

  • Jeroen Blokland
    Jeroen
    Blokland
    Portfolio Manager, Robeco Global Allocation team

The ‘R’ word has reared its ugly head again. And that's got everything to do with today's graph, which shows that the US yield curve has flattened considerably. In the past whenever the yield curve has inverted, a recession has not been far behind. But is that the case this time?

A flattening of the yield curve means nothing

Let's go back to the graph for a minute. It shows that when the yield curve (blue line) inverts, i.e. the yield on short-dated paper (2-year in this case) is higher than that on the longer-dated issues (10-year in this case), there will be a recession (gray areas) in the foreseeable future. But that doesn't answer our question. In fact, the graph doesn't actually provide us with an answer. A flattening yield curve, where the spread between the yields on long- and short-term bonds becomes increasingly narrow, but is still positive, doesn't mean we are heading towards recession. Just look at the red arrows. Since 1977, there have been six periods in which the yield curve flattened significantly without any subsequent recession. But, there have also been five periods when the yield curve inverted that did herald the start of a recession.

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Inversion?

The yield curve usually inverts if 1) the central bank raises short-term interest rates (too) quickly to prevent the economy from overheating and/or 2) investors become so pessimistic about future economic growth that they push down yields on long-dated issues. But how realistic is that?

Let's start by looking at the Federal Reserve. If anything has become clear, it's that the Fed wants to have interest rates rise to a neutral level as slowly as possible. Now, there is some discussion as to what that neutral level is, but monetary policymakers all agree that it is not the Fed's current rate of 1.25%. The graph above shows that when the Fed has completed a hiking cycle, which has typically involved raising interest rates above the neutral level, this has often − though not always − been followed by a recession. It should come as no surprise that this is not currently the case. That of course doesn't rule out a recession altogether. The snail's pace of monetary tightening, after years of exponential easing, increases the odds of the Fed falling behind the curve. In other words, that it will respond after the fact and then later be forced to take drastic measures to ensure the economy doesn't overheat, potentially culminating in recession.

And now for the long-term rates. Are investors already anticipating a recession and pushing 10-year yields down? I don't think so. These have been fluctuating between 2.20% and 2.60% for more than a year now and are definitely not showing a downward trend. Over the last two quarters, growth has picked up and in the absence of any unexpected hiccups, the US economy should continue growing in the quarters to come. There are many signs that this will be the case. Confidence among US manufacturers, one of the best predictors of future growth, is high and US consumers have rarely been so optimistic. The St. Louis central bank uses this and other macroeconomic data in a model, which then predicts the odds of recession. According to the model, the risk of recession is currently almost non-existent.

Central bank disruption

Given the sound economic conditions, yields in the US should actually be much higher. But central banks are keeping them down. While it's true that the Fed is shrinking its bloated balance sheet ever so slightly, the pressure on yields can still clearly be felt. Moreover, other central banks are still buying up whatever they can get their hands on like there's no tomorrow. As a result, yields are much lower in the Eurozone and Japan, making US bonds still relatively appealing to many bond investors, which also keeps yields down. It seems obvious to me that in spite of claims by some monetary policymakers to the contrary, central banks everywhere, are not only influencing, but are actually disrupting the yield curve. That's part of the reason why I can safely say that recession is still a long way off.

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