Investors are sometimes like astrologers, they are constantly on the lookout for signs of a coming windfall or disaster. The field of technical analysis (studying charts to determine future price movements) is pretty much the embodiment of that.
One indicator that historically signaled a coming recession occurred recently, with the longer term US Treasury bond yields falling below the 1 year bond yield. This phenomenon is known as the Inverted Yield Curve. This prompted a sell off in equities last week.
Today I’ll explore the history of this phenomenon, possible reasons why it happens and how I would react to it.
What is an Inverted Yield Curve?
As you may know, MAS issues bonds with varying tenures, from 3 months to 30 years. A yield curve is a graph plotting of Treasury bond yields against the respective Bond Tenures.
Normal Yield Curve
In an expansionary / inflationary environment, the long term yields are higher than short term yields. This creates a normal yield curve sloping from the bottom left to the top right.
There are many ways to explain this:
- In an inflationary environment, inflation is high. As such, bond investors require a higher long term interest rate to compensate them adequately for investing in the bond after adjusting for interest.
- Many things can happen in a longer term bond, as such interest rates have to be higher to compensate investors adequately for the increased risk.
- Bond investors are expecting future growth in the economy to be able to support the higher yields.
The list goes on and on. The common theme in all the reasons is that the economy is expected to grow and expand, which is a good thing.
Inverted Yield Curve
In a deflationary / contracting environment, long term yields tend to be lower than that of short term yields. This creates a yield curve that is inverted in shape.
The flip side of the explanation can be as follows:
- Investors are fearful of the short term prospects of the economy. As such, demand for long term bonds surge, pushing up bond prices, in the process pushing down bond yields.
- Investors expect Inflation to stabilise or even deflate, as such people pile into safe-haven long term bonds.
Significance of the Inverted Yield Curve
The Inverted Yield Curve has been quite a reliable historical indicator for recessions in the US. The inversion of the yield curve typically occurs 6 to 24 months prior to a recession.
The New York Federal Reserve publishes the historical yield spread between long term yield (10 year yield) and short term yield (3 month yield). A negative spread indicates a inverted yield curve.
The blue areas indicate where major recessions have occurred in US history. As you can see, a negative yield spread have preceded every recession in the US. As at February 2019, the yield spread remains barely positive at 0.2408%.
Interestingly, the New York Fed also publishes the probability of a US recession in 1 year based on historical yield spread data. The probability has been on a uptrend recently in tandem with the decrease yield spreads.
Currently, it estimates the probability of a US recession in 1 year at about 24.6%.
How is the yield curve at the moment?
US Treasury Yield Curve
The US Treasury Yield Curve has been inverting over the past year. This process is illustrated below.
US Treasury yields across the board has declined. At the same time, medium term yields have experienced an inversion, while long term bonds remain higher than short term yields. This created the concave shape in the yield curve above.
Singapore SSB Yields
The process of inversion is also evident in Singapore treasuries. The easiest way to illustrate this is from the SSB yield trends.
As you can see here, short term yields have been rising while medium and long term yields have been dropping. While the Singapore yield curve has not inverted yet, it has certainly been flattening over the past year.
Is a recession really coming?
Honestly, I do not know for certain. And anyone who tells you that they are certain of a recession is likely taking at most an educated guess.
If you trust historical trends, then yes it is coming. There are certainly signs that support that thesis. Between Europe’s persistent struggles and anaemic growth, China’s extraordinary debt levels, and issues in various emerging markets (Brazil, Venezuela, for example), one could argue that collapse of any one of these could send shock waves across the world. We are also 10 years into the bull market cycle, as such we are long overdue for a recession.
At the same time, there are also reasons why a recession is not coming at the moment. Former Fed Chair Janet Yellen argues that yield curves have a tendency to be flattish now. She also feels that US growth is slowing but not recessionary. Chief Economist at Allianz Mohamed El-Erian also argues that US economic indicators like low unemployment and high job creation figures continue to highlight the strength of the US market.
My own take
Personally, I take the middle ground and feel that while a recession is not imminent, it should happen in 1-2 years time. I share most of the views of legendary hedge fund manager Ray Dalio on this, so I’ll let him do the talking.
This view underpins my cautiousness in recent years by shifting towards a more income focused investing approach, while also choosing not to go 100% cash. I’m a believer in time in the market and not timing the market, but I think we should proceed with caution over the next few years.
What do you think of the inverted yield curve? Is a recession coming? Do let me know in the comments!
If you missed my previous post
3 Lessons from my Top Investment Losses