A Bond yield inversion is when short-dated yields are below long-dated yields, signalling the market anticipates lower interest rates in future, due to weaker economic growth.
The US Government Bond 3-month/10-year spread has been inverted for nearly three months, though recently corrected.
In approximately the last 50 years an inverted yield curve has proceeded a recession, that has occurred between 3 months and 27 months post the start of the yield inversion, and the stock market has lifted on average approximately 15% following the inversion. There was one false positive in 1965 after the spread inverted for approximately three days, and a recession did not subsequently occur.
An inverted yield curve is one of the better predictors of a future recession, so should investors be concerned about the most recent yield inversion?
Firstly there remain multiple risk factors in the global economy that could negatively influence the global economy and the stock market, so with or without a yield inversion investor should already be conservatively positioned.
Bond yields are already low and so crossing yields or inversions may not be as significant as in the past. Importantly government bond markets are more distorted by central bank bond-buying than any time in history, thus the bond market no longer trades on its merits, but is distorted by the central bank and possibly derivative activities.
It is possible the convergence of multiple technologies that also act to drive costs down could create something of a deflationary, though positive economic growth environment. Granted this is unusual, however. so is the convergence of so many influential technologies in the current time period.
Adjusted for inflation there is currently approximately US$17 trillion in negatively yielding bonds, which means large investors are either positioned for a coming further decline in bond yields or a significant decline in other asset classes to offset their bond holding costs. Fund managers managing US$17 trillion are usually very well informed, need to move early, hold highly liquid assets and above all avoid significant losing investments. Given that negatively yielding bonds jumped very quickly higher, it tends to suggest that these investors moved together on some type of knowledge or news. Many of these investors are aligned with major international banks.
There are concerns in the market that China has significantly more US dollar-denominated debt that must be either paid back or rolled over than has officially been advised by the government. This concern along with the ongoing trade war with the US is in part pressuring the Yuan lower. The Yuan hit an 11 year low against the US dollar in the past week, and China further acted to control fund flow out of the country and to ban increased US dollar-denominated debt. The Yuan movement down against the US dollar, despite Chinese efforts to hold the currency in place, suggests the market’s view is that the US is winning the trade war.
At the start of 2019 US analysts estimated company earnings would lift in the year by 7.6%, however recently this number has been revised lower to 2.3%. In addition to weaker US earnings estimates there are multiple other global economic concerns including weaker growth in Germany, Brexit, Japan growth, Italian debt, bank and political concerns, technology impacts on jobs, not to mention high government and consumer debt loads around the world with central banks poorly positioned to use monetary policy to reduce these risks.
Locally in Australia, household debt to income is at record levels and the country is significantly exposed to a slowdown in China, should it continue to occur.
Clearly there are more reasons to be positioned conservatively than just a US inverted yield curve.
The futures market is currently indicating an approximate 40% chance of a US recession in 2020. This obviously accounts for the great variation in opinions in the current environment; effectively it’s a coin toss.