The bond markets are signaling increasing concern over the economic outlook. For the first time since the global financial crisis, the 10-year US bond yield briefly fell below the 2-year US bond yield, a development seen by many as a precursor to a US recession and a sell signal for equity investors. Meanwhile, the yield on the 30-year US Treasury hit a record low, below 2%, suggesting investors are expecting low rates to persist for the long term.
We believe that recession fears are overdone. But investors should prepare for a more sustained period of lower interest rates.
We would caution against seeing the inversion of the yield curve as an infallible predictor of economic contraction or a bear market.
- Not every inversion has been followed by a recession. Of the last 10 times the US curve inverted, there was no recession for the next two years for three of them. Even when recession did follow an inversion, there was a long and variable lag. Recessions started, on average, 21 months after an inversion, with a range of 9–34 months.
- Inversions don't provide a sell signal for equity investors. Since 1965, the S&P 500 returned an average of 8% in the 12 months following a 2/10 inversion.
- A yield curve inversion may be even less likely to signal a recession this time around. Longer duration US Treasury yields, along with global yields, are being suppressed by the large volume of bonds held by the Federal Reserve, the European Central Bank, and the Bank of Japan.
- In the past, inversions typically occurred when rates were rising. This time, it is happening as rates are falling. The only other time this happened was in 1998. In that instance, the curve re-steepened, and there was no recession over the following two years.
Added to this, we do not see signs of an imminent recession in US data despite a weakening of business investment. US GDP expanded at an annualized 2.1% in the second quarter, with strong consumer spending helping to compensate for declining business investment. The Fed has cut rates preemptively. We expect further easing to help support the economy, partially offsetting the damage from the trade conflict.
Of course, a further escalation of the trade dispute would increase the economic risks. A 25% tariff on all Chinese imports would raise the chances of a 2020 US recession from 25% to 50%, in our forecasts. However, this is not currently our base case. President Trump's decision to delay imposing a 10% tariff on the full USD 300bn of goods suggests some concern over the impact of the trade dispute on the US economy, reinforcing our view that it is unlikely that tariffs will move up to 25%.
However, while we don't expect a recession, we think investors should prepare for a more sustained period of lower interest rates. Alongside the aforementioned structural factors, the trade conflict is contributing to a period of sub-par economic growth. The pick-up in business investment and manufacturing that we expected the second half of this year now looks set to be postponed as sentiment remains weak. We therefore see a further 75 basis points of easing by the Fed, and see only a gradual rise in the 10-year yield from 1.6% today, to 1.9% in 12 months.
Overall, the combination of muted growth and low yields creates a conducive environment for carry strategies, in our view. In our FX strategy, we recently increased the size of our overweight in a basket of high-yielding emerging market currencies (Indonesian rupiah, Indian rupee, and South African rand) against a basket of lower-yielding currencies (Australian, New Zealand, and Taiwanese dollars). We are also overweight long-duration Treasuries, as a hedge against the equity risk in our portfolios if recession risk rises.
The bond markets are signaling increasing concern over the economic outlook. For the first time since the global financial crisis, the 10-year US bond yield briefly fell below the 2-year US bond yield, and the yield on the 30-year US Treasury hit a record low, below 2%. We would caution against seeing the inversion of the yield curve as an infallible predictor of an economic contraction or a bear market. We believe that recession fears are overdone, but investors should prepare for a more sustained period of lower interest rates.