The S&P 500 fell 1.9% on 22 March, its worst fall since 3 January, after a part of the US yield curve inverted for the first time since 2007. Disappointing European and US PMI data and dovish signals from the Federal Reserve earlier in the week helped push 10-year Treasury yields to 2.44%, fractionally below the 3-month Treasury yield of 2.46%. Separately, after the market close on Friday, the Department of Justice announced that Special Counsel Robert Mueller had submitted his report on Russian interference in the 2016 election.
An inverted yield curve (when long-term rates are lower than short-term rates) is seen by some in the market as a harbinger of recession. But we do not see cause for alarm:
- Global economic growth is moderating, not stalling. US growth is decelerating back to "trend" levels of 2%–2.5% as the benefits of tax cuts and higher government spending are fading. Growth in China is also decelerating largely due to government policies to shift the economy toward consumption and innovation. Slower global growth appears to be having a negative impact on Europe. That said, a US recession still appears unlikely. Leading indicators in the US such as new claims for unemployment insurance and access to capital remain healthy. The Federal Reserve has paused raising interest rates, and we believe that Chinese policymakers will continue to increase stimulus.
- While it is true that recessions and bull-market peaks are usually preceded by an inverted yield curve, the time between inversion and the peak in the market has averaged almost two years in the last three bull markets. And stocks have historically performed quite well over this period. Since 1960, the S&P 500 has rallied an average of 15% in the 12 months before the 2y/10y spread hits zero, and 29% from the point that the curve inverts to the equity peak
- This time may indeed be different. Chicago Fed President Charles Evans on Monday noted that there has been a secular decline in long-term interest rates and in such an environment it’s more natural for yield curves to be flatter than historically. Also, last September the FOMC stated that: "On the one hand, an inverted yield curve could indicate an increased risk of recession; on the other hand, the low level of term premiums in recent years – reflecting, in part, central bank asset purchases – could temper the reliability of the slope of the yield curve as an indicator of future economic activity."While a US recession doesn’t appear imminent, the Fed’s dovishness has been insufficient to allay fears about the weakening in growth that lies behind the shift in policy stance. Partly for this reason we recently reduced our equity exposure. We remain risk-on through our overweights in US equities and emerging market USD sovereign bonds. Regarding the Mueller report, details may not become public for some time. As we described in our recent report on the investigation, markets might have a knee-jerk negative reaction to the release of the report. However, in prior episodes of presidential political controversy, it has been hard to identify any direct market impact.