August 19, 2019
As you probably heard, the 2-Year and 10-Year US Treasury bond yield spread “inverted” for a brief period last week. In simple terms that meant that bond investors believed they could get better returns on 2-Year bonds which indicated a lack of confidence in the longer-term health of the economy. Did global markets overreact to this event? Well it is true that each of the last seven US recessions have been preceded by a 2s-10s spread inversion However, there is plenty of discussion around whether this time is different.
Let’s discuss some of the points that suggest that this may not be as strong a predictor as in the past. Those advocating this position note that the inversion was temporary and was apparently spurred by political statements and global economic re-positioning. The inversion was very short lived and had been corrected by the day’s close. Many market prognosticators suggest that an inversion event should be persistent for several weeks before true forward-looking statements may be made. Moreover, there are significant differences in the global sovereign fixed income markets between this cycle and most of our recent past. The longer-term US treasury rates have been actively managed by the Federal Reserve since the previous recession through their bond-buying program that sought to provide stability and strength in an otherwise light market. These actions have for years artificially decreased the yields (increased prices) on longer-dated US bonds in an attempt to increase economic activity. This bond-buying was in the process of being reduced until the end of 2018, when the Fed reversed course and decided to hold their portfolio at a steady principal value and began reinvesting matured capital. Combining this with recently increased short-term rates, the spread between short and long-term bonds has been small for many months.
On the opposite side of the debate, history has shown a strong correlation between spread inversions, temporary or not, and upcoming economic recessions. According to Credit Suisse and Arielle O’Shea, “a recession occurs 22 months after an inversion in the two-year/10-year rate curve, on average.” It is important to note, as always, that past performance does not indicate future results, but when taken in combination with other warning signs, such as economic contraction in Germany, a continued slowdown in China, and global trade uncertainty, even a short-term inversion of the 2s-10s spread could suggest larger issues are to come. These larger issues may provide insight into the significant market moves seen in US equities immediately following the inversion. When uncertainty is high extra precautions should be taken to protect one’s portfolio. While events such as those seen last week should be kept in context, investors should now be particularly cautious when making investment decisions. These are times when it is crucial to have the discipline and focus of a thoughtful long-term investment strategy.