Macro matters

Yield curve inversion and recession jitters

Interest rates take a big step down | The yield curve inverts and alarm bells sound | The economy is cruising along, but risks loom

Lara Rhame
March 28, 2019 | 8 minute read

“Thud!” That’s the sound of interest rates falling all over the world as growth expectations fall flat. Add the echo of central bankers promising accommodative policy that has gotten us… where? Here, right back at low-growth potential. Markets have not seemed very inspired recently.

Last week, an important segment of the U.S. yield curve inverted, which set off cautionary alarm bells for many investors. While we see a recession in 2019 as unlikely, we highlight our favorite indicators to track closely. For investors, heightened concern will continue to cause volatility, and we expect low interest rates to cast a shadow on investors looking for income.

Interest rates take a big step down

On a recent Friday, March 22, the German Markit manufacturing sentiment indicator served up a big downside surprise, falling to 44.7 in March. This data miss was blamed for sparking a global core bond rally that pushed the German 10-year bund back into negative territory for the first time since late 2016 and caused the Japanese 10-year to drop to -7 bps (also a late-2016 low). In the U.S., the 10-year Treasury yield initially sank to 2.42%, a 15-month low. The move was widely summarized by the now-tired-feeling headline of “global growth concerns” and has since continued. On March 28, the U.S. 10-year Treasury yield dipped to 2.35%, 37 bps below where it started March, and 88 bps below its peak in November of last year. Equities reflected this general sense of malaise, with the S&P 500 off 1.6% over the past week, and the Russell 2000 is down 2.1% in the same time frame.1

The yield curve inverts and alarm bells sound

This drop in the long-term interest rates pushed the 10-year yield below the 3-month Treasury bill rate, causing this part of the yield curve to invert for the first time since 2007, and instantly setting off alarm bells about recession. The 3m-10yr yield pair is one of the most often-watched measures of how steep or flat the yield curve is, and when this difference in yields turns negative – otherwise known as yield curve inversion – it is widely considered one of the strongest predictors of recession in the next 12 months. Another regular barometer of yield curve inversion, the 2-year to 10-year spread, is not inverted – the spread is still a positive 11 bps – but the yield curve is flattening all over. Perhaps some of the most ominous news has come from Fed funds futures, where the chance of a rate cut by December 2018 has jumped to 75% from less than 25% ten days earlier.2 Many curve watchers view the inversion of the Fed funds futures curve as the preferred recession indicator.

The economy is cruising along, but risks loom

Statistical models that use the slope of the yield curve typically predict a recession to start 9 to 18 months after the yield curve inverts.3 If we started some “end of expansion countdown” with the 3m-10yr yield curve inversion on Friday, March 22, what could cause a recession in the next year?

The unemployment rate is near multidecade lows. The consumer accounts for about 70% of our economy, and consumer confidence remains high, having mostly recovered from the post-shutdown dip. The recent drop in mortgage rates is showing signs of breathing fresh life into home sales, and the household savings rate is relatively high, particularly for this late in an expansion. The government still has room to enact fiscal stimulus, as well. From this vantage point, it seems likely the economy could slow to 2.0% in 2019, closer to potential, after growing 2.9% in 2018.4 But a recession this year seems like a relatively low-probability event.

There are several risks on the horizon that could derail our economic fortunes:

  • 2020: Many forecasters already have their eye on 2020 as a candidate for a recession simply because the 2017 fiscal stimulus package will no longer be adding a growth tailwind. This comes at the same time that the fiscal cliff may cause the government to cut back spending. Monetary conditions may also be tighter next year as previous Fed rate hikes, which hit the economy with a lag, should also be having their full impact. Yield curve flattening is part of the common narrative spun by those forecasting a 2020 recession.
  • The rest of the world: The global economy can impact the U.S. economy through decreased U.S. export demand, lower multinational revenue, and weaker sentiment in general. It is doubtful that slower growth would in and of itself cause a U.S. recession, but it could cause slow growth to turn into no growth. Recent data have not been good in this regard, as the EU and China are both showing signs of nontrivial growth deceleration.
  • The talking heads: Many forecasters rank one of the top risks as being “talked” into a recession – that is, a policy mistake or rhetoric that adversely impacts the business and financial market outlook.

What we are watching now

If “recession watch” has indeed begun, here are our two favorite indicators investors may want to stay focused on:

  • Consumer confidence, and in particular, the present situation indicator. While a sharp drop in consumer spending has the potential to stop our economy fast, consumer confidence indicators continue to look pretty good. Consumer confidence remains close to expansion highs; the present situations index moved lower in March off an 18-year high in February.
  • Initial jobless claims. This little weekly indicator is historically one of the timeliest indicators of recession. Should jobless claims climb fast, it would be an indicator that companies are rapidly changing their hiring. Once again, however, the good news is that the four-week average was 217,000 in the week ending March 23, close to multidecade lows.5

How about financial markets?

We wrote in late February about the possibility that equities could be sailing into headwinds. Economic and market activity since has done little to change our view that investors – both equity and fixed income – could indeed face challenges in the months ahead. Some of the challenges could include:

  • Paltry core fixed income returns.  Downside growth surprises are cementing policy rates in at extraordinarily low levels. Without inflation, this is spreading across the yield curve. Low core yields and real rates at, or close to, zero mean investors could see a near-term bump in traditional fixed income performance. The Barclays Agg has returned 1.87% month-to-date in March, but with rates already this low, real income returns are likely going to have to come from beyond the core.6
  • High yield bonds shine. Recent weeks have produced a particularly constructive environment for high yield bonds, particularly with the U.S. economy on solid footing. The Fed’s shift this year could encourage investors to continue to diversify their holdings within fixed income, including high yield bonds.
  • Equity markets could be squeezed. Challenges include the late-cycle higher-wage trends that could cut into earnings, trade concerns and broad growth concerns. On the upside, companies still have significant resources to continue to engage in buybacks.
  • Volatility. We’ve seen several stark reminders recently that normally second-tier indicators can spark global market moves, particularly with the uncertainty surrounding slower growth.

Our bottom line is that it appears likely that we continue to see slower growth in 2019, which could perhaps even swoon uncomfortably below potential. This could be enough to keep volatility in equity markets high while interest – and income – may remain low.

  • Bloomberg, equity performance on March 27 vs. March 21, 2019.

  • Bloomberg, Fed funds futures pricing refers to December 2019 futures contract, pricing on March 28 vs. pricing on March 19.

  • “Information in the yield curve about future recessions,” Federal Reserve Bank of San Francisco, August 27, 2018.

  • Bureau of Economic Analysis.

  • U.S. Department of Labor.

  • Barclays Agg refers to the Bloomberg Barclays U.S. Aggregate Bond Index, which is the common benchmark for a traditional fixed income portfolio.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

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Lara Rhame

Chief U.S. Economist + Managing Director

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