Asset Management

Markets Finally Have Yield Curve Moment: Industry Comment

Jackie Bennion Deputy Editor August 16, 2019

Markets Finally Have Yield Curve Moment: Industry Comment

Wednesday saw the US yield curve invert for the first time in over 10 years. Fund managers react.

Hawkishly watched as a litmus test for recession, this week's US Treasury yield curve inversion, which has been threatening and finally succumbed on weak economic data from Germany and China, rattled markets and hastened a retreat into perceived safer haven assets. Below are some quick reactions from fund managers on what this may signal (or not) for monetary policy and the odds of tipping into recession.

John Stopford, head of multi-asset income at Investec Asset Management
“2019 has seen the US yield curve inverting for the first time in over 10 years. Given that yield curve inversions have preceded the last seven recessions, market participants are speculating whether the countdown to the next recession has begun.

“We believe that an inverted yield curve is an important signal that warrants attention. However, in our view, it is more relevant as a signal of the market’s view that monetary policy is too tight and needs loosening.

"While such monetary policy easing is often associated with periods of recession, we do not believe that a yield curve inversion automatically suggests a recession is imminent, particularly if the central bank responds proactively by cutting interest rates and with sufficient magnitude. However, by placing too much emphasis on this so-called relationship, there is the danger that it becomes self-fulfilling, meaning we cannot ignore it.

“In our view, the yield curve is just one of a number of signals that have a fairly good track record of deteriorating ahead of a recession, with lead times of between six and 24 months.

"We think it is important to look at these other signals alongside the yield curve in order to get a better sense of how the risk of recession is evolving, assuming history is a guide.

"Some of these measures are suggesting that the probability of a recession is indeed rising, but most still suggest that this is a tail risk in the next six to 12 months rather than the central case, and some indicators have yet to signal a particularly elevated risk. This suggests caution is certainly warranted but it is probably too soon to move portfolios to a fully defensive setting."

Sonal Desai CIO, fixed income CIO, Franklin Templeton
“The recent inversion of the US Treasury yield curve has had the financial press in a bit of a frenzy. I see a glaring contradiction in the fact that so many market participants and commentators emphasise the heightened level of economic uncertainty, and at the same time seem to consider flat or inverted yield curves as foolproof predictors of a recession. I see this as completely misguided - I think the yield curve is telling us nothing about what lies ahead for the real economy.

“Yes, protracted uncertainty on trade is having some impact on business sentiment. But we have lived with trade uncertainty for almost three years now, with very little economic impact. The US economy is holding up well, and now it benefits from a more dovish US Federal Reserve (Fed).

“China has shown a bit of weakness, but not a sharp slowdown; and the latest data show that China’s lower exports to the United States have been offset by stronger exports to the rest of the world. The weakness in Europe is more pronounced, notably in Germany as we’ve seen with recent gross domestic product data, but by no means a collapse.

“The US economy continues to create jobs at a robust clip, even with the unemployment rate already at a 50-year low. Employees’ wages and salaries grew at 4.7 per cent in 2017, 5 per cent in 2018 and 5.1 per cent in the first half of this year. Household consumption powers the economy, and the household saving rate as of June this year is at a very healthy 8.1 per cent.

“In short: the economic data show no evidence that either the United States or the global economy is approaching a recession.

“Government bond markets are still distorted by the major role that central banks continue to play. And now the Fed has cut interest rates and signalled the possibility of further reductions; the European Central Bank has opened the door to a resumption of quantitative easing. Major central banks are essentially inviting investors to ignore the economic data and bet on lower yields.
“So, I think fixed income markets are betting on the Fed, and the Fed has just taken a dovish turn - ignoring the economic data. But this betting on the Fed gives no indication whatsoever on where the economy is going. In other words, I think the Treasury yield curve has no value whatsoever as a predictor of recession. It’s just a good predictor of Fed dovishness, for now, and a sign of some panic in the markets.

“The markets and the Fed seem to be looking at each other, feeding each other’s fears, and completely ignoring what’s actually going on in the real economy.”

Andrew Catalan, head of long-duration, US, Insight Investment
“We see two main drivers of the US yield curve inversion. The first is the relentless demand from foreign buyers. In Europe, for example, there isn’t a single positive-yielding German bund. Also, in Ireland, the 10-year yield (which was above 11 per cent in 2011) is negative too now. On an unhedged basis, US Treasury yields are unmatched, and so foreign investors have been pouring money into the US long end, as central banks and QE have created a shortage of duration.

Secondly, investors are clearly worried the Fed is ‘behind the curve’. Policymakers have appeared reactive to economic data rather than proactive in protecting growth.

Furthermore, the US-China trade conflict is likely structural in nature, so investors are worried the Fed lacks the urgency to insulate the economy through lower rates. While the Fed is not being seen to be over-tightening (and causing a recession) as it famously has in the past, it is being seen as not doing enough to avert a US recession amid the global economic downdraft.

We don’t expect a recession over the next 12 to 18 months, even with announced tariffs on Chinese exports. We expect foreign demand, however, will likely keep a lid on rates.”

Esty Dwek, head of global market strategy, dynamic solutions, Natixis Investment Managers
“While the global economy continues to slow and trade tensions weigh on the outlook, we still believe that we are not on the brink of a US or global recession. At the moment, data is generally pointing towards trend growth, with some exceptions such as Germany, which contracted in the second quarter. Manufacturing remains weak, but services are holding up. In addition, consumers are broadly healthy and the US housing market should benefit from lower rates. US growth for Q2 came in at 2.1 per cent in the preliminary estimate, and Chinese retail sales have pointed to stabilisation.

“The US yield curve has now inverted between the 2-year and 10-year bonds, another ominous sign, although we continue to believe that data is not pointing to an imminent recession and that lower yields are due to dovish expectations and search for yield in the US, given over $15 trillion of negative yielding debt, which now includes some pretty risky names. European worries are also dragging yields down with the Bund, which yields -0.65 per cent for 10-years.

Mohammed Kazmi, portfolio manager at UBP 

This trend could continue
"The yield curve flattening in the US is a position that we have had on since the last Fed meeting, after Chair Powell described the cut as a mid-cycle adjustment, rather than suggesting a series of rate cuts. The lack of data and central bank speeches in the coming weeks suggests that this trend can continue, especially at the long-end of the curve, where optically there appears to be plenty of room to flatten further. Global growth data, including today’s numbers out of China, as well the ZEW yesterday highlight increasing growth risks to the downside, with the outlook clouded by trade uncertainty which shows no signs of disappearing."

Government, fiscal policy
"We prefer flatteners and the long-end of the US rather than European interest rates at this stage, in case growth concerns accelerate further in Germany to the extent that it will force the government to begin looking at options for using fiscal policy, although we do not think we are quite there yet."

Credit exposure
"The flattening of the curve also keeps us cautious in our credit exposure, as the signal is not great for the outlook. To add back to risk from here we would either need some stabilisation in the data, a tangible improvement in the trade war or for central banks to come out and firmly support another leg of monetary easing, that is not currently priced into markets."

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