Fears of an imminent US recession are prematurePublished on 12 April 2019
Recently, the news has been littered with headlines about an inverted yield curve, long seen as a strong indicator of oncoming economic recession in the United States.
The headlines were prompted specifically by the inversion of the 3-month/10-year yield curve. It seems to be too early, on a fundamental basis, to have grave concerns about an imminent US recession, though.
In fact, the 3-month/10-year yield curve only inverted for a few days before returning to a positive reading. Added to this, a 3-month yield is an unnaturally short maturity to consider in the context of a potential US recession.
Historically this curve provided the market with an early warning of, on average, 22-months. That would imply a predicted recession in the first quarter of 2021, if the curve were to invert from here on a sustainable basis, which it shows no signs of doing yet. This does not raise the immediate alarm bells the financial press would have us hear.
Furthermore, the 2-year/10-year and 10-year/30 year yield curves - more fundamentally-based yield curves – have not yet inverted. In fact, the longer curve has recently steepened somewhat. Based on historical data, should they invert, they would project the next US recession on average 18 months following the inversion event.
If the inversion situation were to continue for a more sustained period, experience tells us that the yield curve inverts long before profit growth matures. Both the curve and profit growth metrics continue to be in constructive territory.
Source: Bloomberg & Stonehage Fleming Investment Management Limited. April 2019. Past performance should not be used as a guide to future performance.
If you consider S&P 500 returns in the chart for the five years following historical inversion events, it is notable that most of the inversion events of that period were followed by positive returns for quite some time. The ones that led to negative returns later on were related to the 2000 technology bubble and the Credit Crisis (1998 and 2006 events, respectively). These were exceptional circumstances and not, as it were, ‘normal’ recessions.
Further to these, looking at historic average one-year returns following four different yield curve categories, we do not have grave concerns. The fact that the current curve category (0% - 0.5%) provided attractive results historically provides us with good reason to stay well invested.
Our FedFund predictor index, based on implied treasury yields, has a fair record of predicting rate cuts ahead of time. This occurs when the index in the preceding chart drops into negative territory. Strikingly, this index dropped sharply towards the end of last year, supporting the Fed’s ‘hold’ stance. It has just crossed into negative territory and we should note the growing probability of a potential cut some time this year. On this basis, we have little reason to fear sharply rising interest rates. And as for its ability to assess risks for a US recession, this index puts it only towards the first quarter in 2021.
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