Richard Maparura, Butterfield
One of the challenges that many investors have faced in interpreting economic forecasts is the fact that despite the predictive relationship of the data there are always questions left unanswered regarding cause and effect (the chicken and egg dilemma). A renowned University professor once said, “A model is just a model, it’s not an oracle. It helps us forecast the future, but it might at any point fail.”
The process of making predictions about the economy at a macro level of indicators such as gross domestic product, inflation, unemployment or the fiscal deficit has been used extensively in the past. One of the most popular forecasts or predictions has been the probability of a recession, the big R. After a 10-year bull market, this unpleasant word has made it to the forefront once again. One of the reasons for the elevated discussion around the possibility of a U.S. recession is directly related to the behaviour in the current treasury yields.
Investors normally demand higher yields to buy longer-term bonds, and when those long-term yields decline, it can signal a slowdown in economic growth. On rare occasions, long-term yields can actually fall below yields on short-term bonds – a dynamic described as “yield curve inversion” in the parlance of the markets. Such an unusual event, which last occurred mid-2007, took place on March 22, 2019.
The yield on the 10-year treasury note tumbled to 2.44 percent, its lowest level since January 2018 and just below the 2.45 percent yield on three-month treasury bills. Should longer-maturity bond yields decline even further in the future, investors would be motivated to purchase these bonds to lock-in yields before they decrease even further. The increasing onset of demand for longer-maturity bonds and the lack of demand for shorter-term securities will lead to higher prices but lower yields for longer-maturity bonds, and lower prices but higher yields on shorter-term securities, further inverting the yield curve.
The ability of the treasury yield curve to predict future recessions has recently received a great deal of public attention. The yield curve inversion has been a reliable predictor of recessions in the past with the difference between 10-year and three-month treasury rates being the most useful term spread for forecasting recessions, according to research from the Federal Reserve Bank of San Francisco. This yield curve inversion has proceeded every recession over the last 60 years.
Yet investors are toying with the idea that the Fed may actually cut interest rates by the end of the year. These forecasts are evident in the interest rate futures market, where the odds of another interest rate increase in 2019 have fallen to zero, from about 30 percent in December 2018, whilst a chance of a decrease in rates has risen to over 29 percent in 2019.
Since Fed chairman Jerome H. Powell first spoke about newfound patience on whether or not to keep raising interest rates, U.S. stocks have soared more than 15 percent. Arguably, Fed rhetoric is not the only reason the market is advancing; rising hopes for a U.S.-China trade deal has also helped to lift the important technology and industrial sectors, providing a boost to markets overall.
Adding to the mystery, the stock market has risen despite the concerns about growth prospects and an apparent global slowdown. Economists expect that the U.S. will grow at an annualised pace of less than 2 percent in the first quarter, a notable decline from the 3 percent growth posted in 2018.
Should investors ride the tide with the market or start to consider the forecasting power of an inverted yield curve?
Generally speaking, lower yields on long-term U.S. bond markets suggest investors are worried about the long-term prospects for the economy. However, Campbell Harvey, a Duke University finance professor whose research first showed the predictive power of the yield curve in the mid-1980s, stressed that an inversion must last, on average, three months before it can be said to be sending a clear signal. If that does occur, history shows that the economy will fall into a recession over the next nine to 18 months. But even with the yield curve’s track record for predicting recessions, Professor Harvey emphasised that there was no such thing as certainty in economic forecasting.
Janet Yellen, former chair of the Fed, recently commented that the yield curve inversion in the U.S. bond markets could signal the need for a rate cut, but not a prolonged economic downturn. In contrast to times past, she argued that there is a tendency now for the yield curve to be very flat, adding that it is now easier for inversions to occur. She emphasised that it certainly does not signal that this is a set of developments that would necessarily cause a recession.
Could these views and the market trend be suggesting that the predictive power of this economic forecasting indicator is fading? Or now that one of the most reliable recession indicators in the market has been triggered, investors across the globe should start to worry that the U.S. economy is heading into a recession?
Sources: New York Times, Federal Reserve Bank of San Francisco (FRBSF) Economic Letter, CNBC
Disclaimer: The views expressed are the opinions of the writer and, whilst believed reliable, may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.