Peter McMurtry, B.Com, CFA, Financial Writer for Do-It-Yourself Investors
Monthly Investment Newsletter https://mcmurtryinvestmentreport.ca
Historically the US yield curve, difference between 2 and 10 year US Treasury yields, has been a reasonably good predictor of an impending economic recession.
Normally when the yield curve turns negative, where 2 year yields exceed 10 year ones, an economic recession occurs within six months.
Today the current spread between the 2 and 10 year yields has narrowed to 55-60 basis points. Each basis point equals 1/100 of 1%. Last year the spread was 131 basis points and during the last recession on August 2007 the spread was only 21 basis points.
The reason that a negative yield curve results in a recession is the chartered banks’ interest margins deteriorate to the point that they stop lending money where there is no profit incentive to do so.
Does the recent flattening of the yield curve signal danger ahead for the economy?
We have all heard investment strategists and economists state that it is different this time and that we should really not worry about an impending recession. Are they correct?
When the supposed experts make statements like this, I remain cautious until I can review all the evidence to prove their point.
Currently the demand for US treasury bonds remains very strong in a world where global fixed income yields are historically low.
The German 10 year government bond yields 0.3%, a full 2% less than its US counterpart.
The Chinese government continues to invest in mid – long US treasury bond maturities and this has resulted in the yields on the longer maturities coming down.
At the same time the US Federal Reserve Bank has started to increase short term rates and this has exacerbated the flattening of the yield curve.
Consequently the flattening of the yield curve looks like it is principally a result of the current supply / demand picture for US Treasuries and not the predictor of an impending recession as has been the case historically.
The current average bond yield spread between Moody’s US Aaa and Baa corporate bond and US Treasury bonds is 2.20% which is only marginally higher than the low of 1.85% last year and the 10 year low of 1.25%.
Corporate bond spreads widen considerably when a recession is on the horizon. This is clearly not the case today and the current spreads indicate a healthy economy.
Global interest rates are rebounding gradually off the recent bottom but remain historically low. The US is the only country where the Central Bank has turned more hawkish, but only modestly more restrictive. Under no circumstances does the US Federal Reserve want to raise rates too quickly as this could lead to a recession in short order.
Inflationary expectations are also rising very modestly but remain historically low. Real interest rates (10 year US Treasury Nominal Yield less CPI) are around 1%. Taking into account the strong US employment data, the latest average hourly earnings for production and non supervisory workers rose at a 2.5% rate year over year. These figures do not indicate any inflationary pressures. Technological improvements in all industries leading to automation in addition to deflationary pressures from Amazon and overall food price deflation have helped keep inflation much lower than in past economic cycles.
Assuming that both houses approve tax reform, this will provide a long term stimulus to economic growth. While it is still too early to predict, there is a possibility that this will result in a pickup in inflationary expectations.
The current evidence suggests that the probability of a US recession in the near term is low. We must continue to monitor inflation for any material uptick, but at the moment this is really not an issue of concern.