March 22, 2019—On Friday, the slope of the Treasury yield curve inverted between the 10-year and 3-month Treasuries (in other words, the yield on a 3-month Treasury exceeded that of a 10-year Treasury), with the 10-year yield falling to as low as 2.42% intraday—the lowest since the start of the year—and the 3-month yield holding fairly steady at 2.45% (Figure 1). Financial media outlets sounded the alarm bells, and equity markets sold off sharply by mid-day.
Figure 1: Inverted yield curve
As of March 22, 2019.
We have discussed in prior communications (December 2017 Capital Perspectives: Canaries in the Economic Coal Mine, as well as Flatter Curve, but Expect the Bull to Keep Running from July 2018) the significance of monitoring the yield curve, as it has inverted prior to the last several recessions and become a recessionary indicator followed by investors. Typically, we monitor the difference between the 10-year yield and the 2-year yield, and that measure remained upward sloping but at the smallest differential of the expansion—just 0.12%. Many have cited that the better predictor for a recession is actually the slope of the curve between the 10-year and 3-month tenors, but historically the two have tracked each other fairly closely.
What has caused the curve to invert? We would point to three catalysts:
- Very weak global economic data. Specifically, the preliminary PMIs out of the eurozone and Japan were very weak, with manufacturing deteriorating sharply into contractionary territory in Germany (a 6.5-year low) and France, and holding steady but below 50 in Japan. (A PMI is a survey-based measure that indicates whether businesses are seeing activity expand—a reading above 50—or contract—a reading below 50.) This has led to a flight-to-safety in European markets, with investors bidding up bonds and sending the yield on the 10-year German bund back into negative territory for the first time since 2016. Negative-yielding bonds in regions like Europe and Japan make the yield on U.S. Treasuries—even at just 2.5% for a 10-year note—look downright attractive (Figure 2), which raises demand and sends yields even lower. In this way, low yields outside of the U.S. are exerting a gravitational pull on Treasury yields.
Figure 2: U.S. and international bond yields
As of March 22, 2019.
- Fears about the U.S. economic outlook. While the market reaction to the Fed’s dovish decision (to hold rates steady and signal no further rate hikes for 2019) could have been a sigh of relief, instead, the narrative almost immediately turned to questions about whether the Fed knows something the rest of the market does not. The 10-year yield moved lower on concerns about U.S. growth and a view that inflation will remain below the Fed’s target for the foreseeable future. In general, bond yields reflect expectations for future economic growth and inflation. Meanwhile, the Federal Reserve on Wednesday held policy rates steady, which tends to drive the 3-month Treasury yield, leading to an inversion of the curve. Importantly, we think growth concerns are overdone, and we view the Fed’s decision as being driven more by the reality that inflation is not a threat rather than broader concerns about the U.S. growth outlook. We still expect U.S. GDP growth around 2% in 2019.
- Fed halting balance sheet reduction. The Fed’s March 20 decision included specifications related to the end of its balance sheet reduction, with the September date occurring earlier than many had expected. A larger Fed balance sheet means more demand for Treasuries and lower yields.
What does this mean for investors? It is the clearest sign yet that we are late cycle, but we are not yet opening the escape hatch. Historically, the S&P 500 has never peaked before the 10-year minus 2-year yield curve has inverted. (As a reminder, that yield curve stayed positively sloping as of Friday.) While an inversion has preceded recessions, it has done so by anywhere from 11 months to two years.
We also think it is important to recognize that the shape of the yield curve is a prominent signal on the Fed’s dashboard of market indicators. In the past two cycles, the Fed has continued to raise interest rates despite an inverted curve. We think today is more analogous to the mid-1990s, when the yield curve also inverted but the Fed then held an emergency meeting and ended up cutting rates in response. We are not expecting the Fed to cut rates, but we do think they will hold steady for the time being and not raise rates again until the yield curve “grants permission” to do so.
At this time, we are not panicking about the inverted yield curve. We expect global economic data to pick up in coming months as Chinese policy stimulus gains traction in the economy and U.S.–China trade tensions recede. This should help buoy global trade and, in turn, overseas economic data. At this point, the Fed’s next moves are critical. The central bank has strongly signaled it is not raising rates any time soon, which severely reduces the risk of a recession in the near term. Client portfolios are neutral International Developed Equities versus our strategic benchmark, favoring the U.S. over International, and slightly overweight Emerging Markets Equities. At today’s bond yields, we remain underweight high-quality bonds, instead choosing to hold elevated levels of cash, which offer comparable income and no-duration risk should yields move higher in response to the better economic data we expect. We are by no means dismissing what the market is telling us, but we think it is prudent to continue monitoring the data for evidence that the U.S. growth outlook is deteriorating before reducing risk in client portfolios.
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