Yield curves are one of many tools for forecasting turns in the cycle. How are we to interpret the inversion, since mid-August, of the US Treasury 2-year to 10-year yield curve (‘2s10s’)?
We know from history that yield curve inversions – when the yield on long-term debt instruments is lower than the yield on short-term debt instruments of the same credit quality – occur towards the end of economic and financial market cycles. But there is always debate about which yield curves signal what, and when the next credit bear market – and eventually recession – might truly begin.
Based on our analysis of previous yield curve inversions, we see a high likelihood of credit spreads widening over the medium to long term, regardless of whether we are about to enter a recession. For credit investors this means that active credit management is now essential: active managers can use quality, sector, name, maturity, seniority and regional allocation to position their portfolios. ETFs and other passive approaches, by contrast, are mandated to own 100% of the beta – and all the idiosyncratic risks.
Many parts of the US term structure are now flat or inverted – a classic late-cycle signal. Moreover, the inversion of the 2s10s curve was not the only inversion in government bond markets during August: the UK Gilt curve and the Argentinian external curve inverted too – albeit for quite different reasons! Other local curves, such as Mexico, inverted earlier in the summer.
All US recessions in the last forty years have been preceded by curve inversions; but not quite all curve inversions have been followed by recession. Some inversions are ‘merely’ accompanied by emerging market (EM) crises – like 1998 – which we view as the optimistic scenario for 2019-20.
Every cycle is a little different, though, each with its own unique characteristics. We see two key differences heading into 2020: on timeframes and on sequencing given structurally lower yields globally.
Many investors seem overly relaxed about the timing of yield curve inversion signals, perhaps because, before the previous recession, the yield curve inverted as far as two years in advance. Specifically, last cycle it took until September 2007 for the Fed to cut rates, even though the initial yield curve inversion occurred back in December 2005. This summer, the Fed cut rates in July – one month before the 2s10s inversion in August. So, what took 21 months last time, has taken minus one month this cycle! That argues that timeframes could be more compressed this time round. By the time the Fed first cut rates last cycle, the credit bear market had already started.
Further, if one agrees with the critique that the Fed is behind the curve, it would suggest that rates markets – which are already pricing in over 140 basis points of cuts this cycle – are signaling that recession risk is much higher than the Fed’s own communication. The ‘mid-cycle slowdown’ narrative from the Fed, involving two or three ‘insurance’ cuts of 25 basis points, is looking more optimistic than what rates markets are implying. And yet, credit markets look priced more for the Fed’s scenario. If rates markets prove more prescient, hanging around without adjusting portfolio credit quality and name selection, could prove costly for credit investors.
Secondly, the level of rates is structurally much lower than in the past. This has implications for how we interpret the signals: lessons from 1990s Japan, 2010s Germany and now the UK in 2019, all suggest recessions in developed markets are increasingly likely to occur without a yield curve warning.
Meanwhile, Germany may have just started its second recession of the last decade – it has just recorded its second quarterly GDP contraction in 12 months – even though the 2s10s Bund curve has not inverted since 2008. Here, it is not just a different sequencing, but a case of recessions without yield curves inverting at all.
Nowhere has illustrated the trend better than Japan, where the Japanese Government Bond yield curve has not inverted since 1991 – twenty eight years ago. Yet depending on which definition you use, Japan has experienced five to eight recessions during this time.
There are some specific lessons from history for credit markets. Our analysis of six cyclical yield curve inversions since 1978 shows that credit spreads typically are meaningfully and universally wider 24 months after the initial curve inversion. This occurred regardless of whether there was a recession (5 out of 6 inversions saw a recession soon after; the one outlier in 1998 saw an EM crisis).
If history is a guide, then it is highly likely that BBB to AAA credit quality spreads are at least 38 basis points wider by August 2021, and it is reasonably likely that spreads could widen by a great deal more than this.
The yield curve is just one indicator and ought to be considered as part of a broader analysis. The 10s30s curve has not inverted, which some regard as a positive sign owing to the fact that it has inverted before each of the last five US recessions. The 10s30s might also reduce any potential interference from ‘term premia’ in the US Treasury market. However, we have reservations about this curve segment: it is overly focused on fiscal policy, it ignores monetary policy and it nearly missed forecasting the 2008 recession entirely.
In the final analysis, if cyclical trends rhyme again, credit spreads are going wider longer term. That means active credit management, across the full portfolio toolkit, and careful name selection will be essential for credit investors.
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