One of the high profile issues this week was the brief inversion of the US interest rate yield curve. Whilst the yield curve generally considers the cost of money from one month to 30 year duration US bills, notes and bonds, one of the closest watched benchmark comparisons is the 2 yr v. 10 yr rates. Here is a chart showing this week’s inversion:
So why is this important?
Its main significance is that every US recession since 1955 has been preceded by an inverting of the yield curve and therefore this week’s reversal may also be an indication of an imminent recession occurring.
This is of concern in the current climate due to the signs of economic slowdown in other parts of the globe and the uncertainties arising from Brexit. However, maybe things are not quite as straight forward as that and there are significant differences in the management of economies in today’s world compared with the last century and, indeed, from the lessons learnt since 2008.
It is relevant to remember that earlier recessions followed a yield curve inversion by even 2-3 years and this week’s brief inversion is not therefore a sign of an immediate collapse into recession. But it does indicate certain possible events in the near future.
US notes and bonds are normally fixed rate instruments and therefore when increased buying raises their prices it creates a corresponding inverse fall in the actual interest rate earned from them compared with their nominal fixed rate. Therefore increased buying depresses the long end of the yield curve,
However, in principle, the longer term interest rates should, traditionally, carry a premium over short term rate to reflect the impact of future inflation. So an inverted yield curve does suggest something “abnormal” is going on.
But it is worth remembering that the US yield curve has been extremely flat for some time due to the outlook for a prolonged period of low inflation rates. Therefore the chances of a small and brief dip into negative territory is greater than in previous times and perhaps not so significant as a barometer reading on the state of the US economy.
Although the negative data in other global markets is pointing to a weakening trend, the US market is not yet following suit. For example, retail sales and wages are strong as well as employment. These are not signs of a faltering economy at all.
At this stage, it would seem most likely that the inversion of longer term rates below the short term is mainly reflecting the anticipation of further cuts from the Fed - which would bring interest rates back into a normal shape of a gently increasing curve, reflecting a strong economy and low inflation.
But one cannot dismiss the situation globally, and when Germany also announces it is introducing debt-related measures to boost its economy, then we can be sure there are serious problems around.
We could imagine 2 scenarios:
-Mr Trump’s aggressive tactics in the form of trade negotiations and sanctions will successfully lead to the US resuming its unopposed economic and political supremacy in the entire world boosted by a strong trade deal with the UK and its partners as well as reigning in competition from other superpowers such as China such that growth in those areas means growth in the US as well. This scenario is also boosted by the US being almost self-sufficient in energy.
-Mr Trump’s policies of attempting to force other economies and sovereigns to toe the American line pushes those economies into a weakening situation that turns into an irreversible spiral into recession that inevitably backfires into the US economy, too. And when recession fears hit the US equity markets, which are now at or near record highs, then the ensuing collapse there will be fast and furious and will have a catastrophic impact on other global markets which are currently already weak and vulnerable.
The main hope at present is that the US-China trade disputes can be resolved satisfactorily and soon, and that the Brexit upheavals and uncertainties will also be settled quickly and relatively painlessly. Afterall, the UK is the 5th largest global economy and the EU is another giant trading entity.
From a trading perspective, one can expect the roller-coaster to keep on rocking and rolling - let’s just hope no economies end up sea-sick and falling off the ride…