Inversion does not spell the end of the cycle

Thought of the day

by Chief Investment Office 04 Dec 2018

The US yield curve continues to flatten. Yields on both two- and three-year Treasuries moved above five-year yields on 3 December, marking the first inversion in part of the US yield curve for more than a decade. The more closely watched 2s-10s spread, compressed to an 11-year low of 14bps.

A flattening yield curve traditionally has been seen as a sign that investors expect future growth to weaken, as monetary policy tightening starts to restrict economic activity. An inverted yield curve is seen by some as an early warning sign of an impending recession.

But we would caution against reading too much into the inversion in the middle of the curve:

  • The 2s/10s spread is a better indicator of economic downturns, having inverted prior to the last nine recessions. Our forecast has been for slight inversion in 2s/5s over the next 12 months, it has merely happened sooner than we expected. We expect 2s/10s to flatten to zero, but not to invert.
  • Even if 2s/10s did invert, in our view, this would not mean a recession is imminent. Since 1988 2s/10s inversion has preceded the start of US recessions by as few as 150 and as many as 750 days. And current rates of consumption, investment, and employment growth in the major developed markets are not historically consistent with an impending recession.
  • Economic cycles are often ended by central banks over-tightening. But, over the last week, this risk appears to have receded. Federal Reserve Chairman Jay Powell has said that rates are “just below” neutral and that further rate hikes will be data dependent. The latest FOMC minutes also suggest the Fed may drop the "further gradual increases" language from the December statement.So we do not believe the slight mid-curve inversion indicates an approaching recession. We remain overweight global equities and 10-year US Treasuries, which we believe have priced in the Fed tightening cycle.

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