The increasing gridlock between the United States and China on trade has buffeted the global industrial production cycle. As a result, economies heavily weighted to industrial production, such as Japan, Germany and South Korea, could well slip into recession. Recently, the recession narrative has extended to the US as the shape of its yield curve has become negative (or inverted). But just hold on a minute!
What is a yield curve?
The term ‘yield curve’ refers to the difference between interest rates over different time periods. The conventional view of the yield curve is as a barometer for the current stance of monetary policy. In other words, the yield curve reflects the way markets believe interest rates will change in the future.
These expectations gravitate around whether an economy is expected to grow or to enter a recession. Many people use the yield curve as a short-cut measure of the likelihood of a recession (at Nutmeg, we don’t like short cuts).
Chart 1 examines the association between yield curve inversion and recessions. The curve in this example is based on the ten-year US government bond rate and the one-day federal funds rate.
- A steep yield curve means that the market thinks short-term (one day) interest rates will go up in the future, so the current stance of monetary policy is easy (currently low short-term interest rates).
- A flat or inverse yield curve means that the market expects short-term interest rates to go down in the future, so the current stance of monetary policy is tight (currently high short-term interest rates).
The conventional view is that when the yield curve inverts, not only are current short-term interest rates high, but these high rates are a threat to economic growth. Chart 1 shows that inversions since 1990 have, more often than not, been followed by a contraction in the level of economic activity (periods of recession are shaded in grey on the chart)¹.
But it is not a failproof rule with no recessions occurring in 1995 or 1998. And even when recessions do occur, the timing is variable.
Short-term interest rates are not high
We need to remember that the curve is only a summary indicator of the stance of monetary policy. A more direct indicator is the level of overnight (short term) interest rates. Chart 2 shows that the federal funds rate has not reached its long-term average, so it is difficult to characterise rates as high or current monetary policy conditions as tight. An equally valid rule of thumb about recessions is that they are only likely to happen when short-term interest rates rise above their long-term average level. On this score, it seems premature to worry.
Another way of looking at the tightness of monetary policy is the level of real short-term interest rates. Chart 3 shows that real interest rates are negatively (or inversely) correlated to yield curve shape. The left-hand scale on the chart has been inverted. Real short rates should be high when yield curves are inverted. But they are not high. In fact, they are near zero.
The world is not Japan
This means the current inverse-shaped (negative) yield curve can only reflect tight monetary policy if we are now assuming that zero real rates are the new normal and the new long-term average. You may have seen media reports refer to this phenomenon as the “Japanification” of global economies². Japan has had near-zero real average short-term interest rates since the mid-1990s. Japan’s average economic growth since then has only been around 1%³.
The IMF forecasts for world growth are pessimistic, but they are not reflecting such low real economic growth. Chart 4 shows real growth in the 2.5% to 3% range over the next five years. To be sure, this is not strong, but it is not indicative of a new lower real-rate regime.
Yield curve reflects a number of unusual factors
What are some alternative reasons the curve has inverted? If not tight monetary policy, why have long-term interest rates fallen so much relative to short-term interest rates?
- Excessive liquidity has driven up the price of bonds and hence driven down their yield. Under quantitative easing, central banks in Japan and Europe are still engaged in the policy of balance sheet expansion, flooding their financial systems with liquidity. Also, negative short rates in Japan and Europe mean that these longer-term bond markets have become negative yielding and their bond investors are looking to US and UK bond markets to achieve higher returns. This has the effect of lowering US and UK bond yields.
- Excessive caution and pessimism about global trade has led markets to prefer safer bond assets to risky equity assets.
- The US Federal Reserve used this uncertainty as a reason to lower interest rates in July. It is looking to underpin the US economy while inflation remains subdued.
- Interest rates are most negative in regions with high household savings rates and most reliance on global trade, such as Japan and Germany.
Nutmeg not caught in recession hysteria
“Recession” is a buzzword for the media and for market commentary. The current US yield curve shape has been used to whip up a degree of recession hysteria. Nutmeg is not being caught up in this. We do not believe the US economy is at high risk of recession. We think the yield curve is influenced by these other factors rather than indicating tight monetary policy. However, the changed policy stance of the Federal Reserve over the summer has convinced us that still lower yields are possible in the US and UK. We have positioned our customers’ fully managed portfolios accordingly. We will continue to follow local and global developments and stand ready to adjust portfolio asset allocation as we see fit.
- The shaded areas come from National Bureau of Economic Research (NBER). The technical definition of a recession is either two consecutive quarters of negative GDP growth or negative GDP growth over one year ago. The NBER waits a long time before indicating a recession because data revisions are common for up to two years.
- “Why ‘Japanification’ looms for the sluggish eurozone”, John Plender, Financial Times, March 2019. https://www.ft.com/content/1954c468-449a-11e9-b168-96a37d002cd3
- Data from Macrobond.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance.