Will the inverted yield curve lead to recession?

Historically, this has often been the case. But this time may be different.

The US Treasury yield curve, specifically the spread between the 10-year US Treasury rate and the 2-year US Treasury rate, briefly inverted on the morning of Aug. 14. As of early afternoon, the spread was roughly 1 to 2 basis points wide. The brief inversion follows the inversions earlier this year between the spread of short-term rates (such as the federal funds rate and the 3-month Treasury bill) and the benchmark 10-year rate.

The equity market immediately sold off due to fears of a looming recession — of all the macro indicators, the bond market has tended to get it right more often than most others. Case in point: An inverted yield curve that lasts for a prolonged period (not briefly in one morning!) has preceded seven of the past nine recessions.1 And in those seven time periods, the US economy tipped into a recession 22 months following the inversion, on average.1 Interestingly, stocks, as represented by the S&P 500 Index, have been positive, on average, in the 12 months following the yield curve inversion.1

What is our take on the situation?

We would caution investors from assuming that the brief inversion of the yield curve is bound to lead to a forthcoming recession. Business cycles typically end with policy mistakes. In most instances, the policy mistake has been the US Federal Reserve (Fed) over-aggressively raising short-term interest rates to lessen inflationary pressures and/or curb excesses. Importantly, the recessions tend to be preceded by the Federal Open Market Committee raising the federal funds rate above the 10-year Treasury rate — not by the 10-year rate falling below the 2-year rate after the Fed has already completed its tightening cycle.

It might be more constructive to consider periods such as the mid-1980s and mid-1990s. In the mid-1990s, the yield curve briefly inverted, and the Fed countered by keeping rates generally stable over the following four years. This year, the Fed has already lowered interest rates to begin undoing the rate increases/potential policy mistakes of 2018.

In this instance, long rates briefly rallied below the 2-year Treasury rate as the ongoing uncertainty of the US-China trade conflict has been eroding sentiment and slowing business investment. Importantly, protectionism, in and of itself, has historically led to inefficient economic outcomes, but not necessarily recessions. Rather, it’s the uncertainty surrounding the future trade guidelines that has been grinding investment to a halt. In simplistic terms, it is difficult for businesses to plan when they do not know the rules of the game.

In Figure 1, we highlight the weakness in business investment growth, as represented by capital goods orders, as business confidence wavers.   

Figure 1: C-suite confidence has been falling, but is not yet at the 2016 low

CEO Confidence Index: Confidence in the Economy 1 Year from Now Vs. U.S. Capital Goods New Orders Nondefense Excluding Aircrafts & Parts

Sources: Chief Executive Magazine, Bureau of Economic Analysis, Bloomberg L.P., 7/31/19. The CEO Confidence Index is a monthly survey of chief executives. Each month, Chief Executive Magazine surveys CEOs across corporate America, at organizations of all types and sizes, to compile and create an index.

In Figure 2, we highlight the weakness in the ISM Manufacturing Production Index, a leading indicator of future economic activity (below 50 signals contraction), as capital goods orders have fallen.

Figure 2: Growth in capital goods orders has been negative, pointing toward further weakness in production

US Capital Goods New Orders — Nondefense (Ex-Aircrafts & Parts) and ISM Manufacturing Production Index
November 1990 through July 2019

Sources: Institute for Supply Management, Bureau of Economic Analysis, Bloomberg L.P., 6/30/19.

In our view, a silver lining for investors is that the US’ current troubles are largely self-inflicted, the lagged result of last year’s Fed tightening and the lack of clarity on trade from the Trump administration. The Fed has already backed off its tightening stance. All eyes are now on the administration, as we believe there is still time to intervene in this slow-motion accident and avoid a recession.  

What are the investment implications?

Market downturns tend to commence with policy uncertainty. In the near-term, longer duration bonds, lower volatility strategies, and the more-defensive equity sectors may outperform, in our view.  

Ultimately, we believe that a more-significant drawdown would likely lead to US policymakers acting to counteract the effects of the current trade conflict. In our view, “winning” the trade conflict with China is very unlikely, and we hold out hope that the US will recognize this. This may prompt the administration to capitulate and avoid further self-inflicted damage, perhaps by accepting a deal with only minor concessions from China. We would also expect the Fed to respond accordingly with further interest rate cuts and other policy accommodations.

In this environment, we believe the probability of recession has increased, but our base case remains that we are in a slowing-growth environment with monetary policy largely accommodative globally. Typically, that has been a positive backdrop for secular growth companies and credit. Importantly, we note that thus far, US credit markets have largely behaved, and the US dollar has not strengthened meaningfully. We view both as favorable for investors, and we believe that the volatility is likely to create opportunities for selective, discerning investors.

1 Bloomberg L.P., as of Aug. 14, 2019. Recessions are defined by the National Bureau of Economic Research (NBER).

Important Information

Blog header image: Clem Onojeghuo / Unsplash.com

An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.

A basis point is one hundredth of a percentage point.

The federal funds rate is the rate at which banks lend balances to each other overnight.

The Federal Open Market Committee (FOMC) is a 12-member committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

The CEO Confidence Index is a monthly survey of chief executives. Each month, Chief Executive Magazine surveys CEOs across corporate America, at organizations of all types and sizes, to compile and create an index.

The ISM Manufacturing Production Index is published by the Institute for Supply Management. It tracks production in the manufacturing sector and is considered a leading indicator of future economic activity.

The opinions referenced above are those of the authors as of Aug. 14, 2019. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

Kristina Hooper is the Chief Global Market Strategist at Invesco. She has 21 years of investment industry experience.

Prior to joining Invesco, Ms. Hooper was the US investment strategist at Allianz Global Investors. Prior to Allianz, she held positions at PIMCO Funds, UBS (formerly PaineWebber) and MetLife. She has regularly been quoted in The Wall Street Journal, The New York Times, Reuters and other financial news publications. She was featured on the cover of the January 2015 issue of Kiplinger’s magazine, and has appeared regularly on CNBC and Reuters TV.

Ms. Hooper earned a BA degree, cum laude, from Wellesley College; a J.D. from Pace University School of Law, where she was a Trustees’ Merit Scholar; an MBA in finance from New York University, Leonard N. Stern School of Business, where she was a teaching fellow in macroeconomics and organizational behavior; and a master’s degree from the Cornell University School of Industrial and Labor Relations, where she focused on labor economics.

Ms. Hooper holds the Certified Financial Planner, Chartered Alternative Investment Analyst, Certified Investment Management Analyst and Chartered Financial Consultant designations. She serves on the board of trustees of the Foundation for Financial Planning, which is the pro bono arm of the financial planning industry, and Hour Children.

Brian Levitt is the Global Market Strategist, North America, for Invesco. He is responsible for the development and communication of the firm’s investment outlooks and insights.

Mr. Levitt has two decades of investment experience in the asset management industry. In April 2000, he joined OppenheimerFunds, starting in fixed income product management and then transitioning into the macro and investment strategy group in 2005. Mr. Levitt co-hosted the OppenheimerFunds World Financial Podcast, which explored global long-term investing trends. He joined Invesco when the firm combined with Oppenheimer Funds in 2019.

Mr. Levitt earned a BA degree in economics from the University of Michigan and an MBA with honors in finance and international business from Fordham University. He is frequently quoted in the press, including Barron’s, Financial Times and The Wall Street Journal. He appears regularly on CNBC, Bloomberg and PBS’s Nightly Business Report.

Timothy Horsburgh is an Investment Strategist at Invesco. In this role, he develops and communicates economic outlooks and investment insights. Additionally, he researches and creates thought leadership pieces to help articulate the firm’s thematic viewpoints.

Mr. Horsburgh joined Invesco when the firm combined with OppenheimerFunds in 2019. He began his career with OppenheimerFunds in 2010 and worked with the investment strategy team. Previously, he worked in roles in the US and Asia. He has been quoted in the press, including in the Financial Times and USA Today. He has also appeared on CNBC and Bloomberg and spoken on Bloomberg Radio.

Mr. Horsburgh earned a BA degree in both economics and government from Cornell University in Ithaca, New York. He is a Chartered Financial Analyst® (CFA) charterholder and holds the Series 7 and 63 registrations.

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