Does trouble in bond markets mean recession is inevitable?

The bond markets are flashing up recession warnings. Kyle Caldwell explains why, and whether investors should take risk off the table.

For the first time since the global financial crisis, bond markets are signalling the end of the current market cycle is in its final stages.

The closely watched yield curve has 'inverted'; below, we explain what a yield curve is, and why in the past an inversion has spelled bad news for the US economy and, by extension, for global stockmarkets.

Jargon Buster: what is an inverted yield curve?

The yield curve describes how bond yields typically 'curve' up with increasing contract length, notes Ed Smith, head of asset allocation research at Rathbones.

He adds that's because lenders generally demand a higher yield to compensate for the additional risk of parting with their cash for a longer period of time. Moreover, future inflation expectations are a big driver behind the shape of the yield curve; if inflation is expected to be higher in the years to come, yields will in theory rise across the curve.

"In market parlance, the term yield curve is generally used as shorthand for the difference between the yields on the 10-year and two-year Treasury bonds (debt issued by the US government)," he says.

"Sometimes, it's measured by the difference between the 10-year and one-year Treasuries - we favour this over the 10- to two-year curve because it's ever so slightly more stable."

An inverted yield curve occurs when longer-term bonds have a lower yield than short-term ones of similar quality.

"A negative reading is referred to as an inversion, and it is highly unusual. The worrying thing is that it signals the US economy may be overheating in the short run," adds Smith. Typically, in the context of history, a recession has occurred within the following 18 months on average.

While Smith looks out for the difference between 10-year and two-year Treasury bonds, the bit of the yield curve that inverted at the end of last week (22 March) was between the 10-year and three month Treasury bonds.

According to Rory McPherson, head of investment strategy at Psigma, the wealth manager, this signals that investors are worried about near-term risks, as they want more compensation for making shorter-term loans than longer term ones.

He adds: "This has serious knock-on effects for banks, as it can mean that bank lending dries up."

Investors should not be alarmed

But, as McPherson points out, investors should not be alarmed and rush to sell. He points out that historically, the yield curve inverting once has not been a harbinger for a recession.

Instead, McPherson notes that in the past the yield curve has only signalled a recession is nearing when the yield curve has inverted for more than 10 consecutive days. Therefore, time will tell, but the same part of the yield curve inverted again on Monday (25 March) and yesterday (26 March). At close of trading the 10-year US treasury bond was yielding 2.41%, while the three month bond had a yield of 2.46%.

The one-year bond has a yield of 2.44%, so has also inverted, but the two-year bond ended trading yesterday with a yield of 2.24%, so that bit of the yield curve has not inverted.

McPherson adds: "Sustained inversions of more than 10 straight days for the three-month to 10-year curve have generally preceded a recession by an average of 311 days (just over 10 months), with the two-year to 10-year part of the curve (which is not yet inverted) generally preceding a recession by an average of 18 months. In summary, neither of these curves is yet signalling a recession, but they have veered closer that way over the last week."

Esty Dwek, senior investment strategist at Natixis Investment Managers, adds that disappointing economic data in the US due to manufacturing and service growth slowing led investors in the bond market to become more bearish on the day (22 March) the yield curve inverted.

The yield curve inversion was also driven by the market readjusting its interest rate expectations, with the Federal Reserve putting future rate rises on hold for the time being. At the start of 2019, due to the strength of the US economy at the time, the expectation was that a couple of rate rises would be on the cards this year. 

However, Dwek adds: "While an inverted curve is an ominous sign for medium-term growth, a recession is not a foregone conclusion. Indeed, we have seen situations where an inversion wasn’t followed by a US recession."

Dwek points out that US growth "remains sold" but also acknowledges that "we are still late in the cycle", so therefore says that "while we think it is too early to take risk off the table, it is probably too late to add much risk as well."

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