U.S. Economic Outlook

How much should you read into the recent inversion of the U.S. yield curve?

Do interest-rate cuts by the U.S. Federal Reserve (Fed) cause recessions? If you consider yourself to be economically literate, you might smile at the very question. Yet such an interpretation has been one of many in financial markets recently, as investors grapple with the mysteries of the yield curve.

Most recently the catalyst seems to be trade – or more specifically, the recent escalation of the trade war between the United States and China. Shortly after the announcement of additional 10% tariffs on the remainder of imports from China, and the subsequent Chinese retaliation, the U.S.-Treasury yield curve, as measured by 2-year and 10-year U.S. Treasuries, inverted for the first time since 2007. Market commentators and participants were quick to note that such an inversion of the yield curve correctly "predicted" at least the last five recessions. Therefore many were equally quick to treat it as the ultimate recession signal. Are they right?

Well, to state the obvious, just because inversions of the U.S. yield curve have preceded some of the last recessions, it does not mean it "predicts," let alone causes such a downturn. And the timing is ambiguous at best. On average, around 20 months passed between a yield-curve signal and the start of a recession. But there is a lot more to the yield curve than casual observers realize, which is why we want to take a closer look in this economic outlook.

Mainstream interpretations of the inverted-yield-curve phenomena start with the basic idea that the yield curve can be decomposed into two components: investor expectations on future inflation and of real interest rates. More sophisticated models add in the compensation investors require for taking the uncertainty surrounding those expectations – the inflation risk premium and the real-rate premium; the sum of these is the term premium. Moreover, those components can be tested statistically for their significance in "predicting" recessions. One upshot of such exercises is that, as a recent paper by several Fed economists put it, that "monetary easing, either current or expected, is associated with an increase in the probability of a future recession."[1] Of course, correlation is not necessarily causation, historically the Fed has been a little late in reacting to a deteriorating economic situation.

Inflation expectations, and the corresponding risk premium, can reflect a long-term perspective and typically have greater influence on the longer end of the curve. Real-rate expectations tend to be more driven by market perception of the economy, and of central-bank behavior, and have a tendency to impact the shorter end of the curve.[2] Translated into the current environment, this implies that persistently low inflation made it more attractive to hold longer-dated bonds in general. This might have been amplified by the decline of market-based inflation expectations since the last recession.[3] Term premiums cannot be precisely measured, but several estimates have shown them to be negative since 2014.[4] Furthermore, some studies indicate that holding bonds nowadays corresponds more to hedge against deflation than to bet on inflation.[5] This implies, as long as the expectations prevail that inflation remains low (i.e. below the central bank's target) it is beneficial to hold nominal bonds. And whenever persistently low inflation expectations coincide with short rates increasing (e.g. Fed-hiking cycle), it seems like the perfect recipe for an accelerated-yield-curve flattening. The final piece to get the curve inverted in an environment when term premiums are compressed would be an event that imposes a major threat to the economy (e.g. investors search for short-term liquidity), or something that is judged as such.

Which brings us back to the trade-war escalation. Timing wise, it appears to have been the final trigger to tip the curve negative. One anecdotal note is that the recently good news flows with respect to the trade war pushed the curve back into positive territory. "So what?" – You might ask. Well, for one thing, it suggests that bond markets appear not to be particularly sophisticated in thinking about trade tensions. As we recently argued, "trade wars do not usually, or even necessarily, cause recessions. They tend to damage how much existing plants and businesses are worth in the long term, not necessarily how much of the remaining capacity might remain idle for a few quarters. [DWS Quarterly CIO View: Macro – Rising risks as of 8/30/19]" They do, however, tend to increase inflation in the short-term and leave both parties to the trade war poorer in the long term than they otherwise would have been. None of which is necessarily good news for holders of nominal bonds.

All of this suggests that the markets are very nervous about a slowdown, even if they are not sure why that would happen. The reaction function seems different compared to the past. The phenomena of a very low term premium, most likely linked to lower inflation expectations, might seem to reduce the significance of an inverted yield curve. But is this the only reason? Recent discussions, like the one at the Federal-Open-Market-Committee (FOMC) meeting in August 2018, suggest that global-central-bank asset-purchase programs and the global demand for relatively safe assets could compress term premiums as well.[6] And it is interesting to observe that inflation expectations started to deteriorate around the time the Fed ended its asset-purchase program in late 2014. Our conclusion is, that global quantitative easing and low inflation expectations might have produced what we call a nervous yield curve. The current episode appears more sensitive to exogenous shocks than the one in the past. We take the signal seriously but do not overreact.

Overview: key economic indicators

2018

2019

2020

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

GDP (% qoq, annualized)

2.5

3.5

2.9

1.1

3.1

2.1

1.8

2.0

2.0

2.2

Core inflation (% yoy)*

1.9

1.9

1.9

1.9

1.5

1.6

1.7

1.9

1.9

1.9

Headline inflation (% yoy)*

2.1

2.4

2.0

1.8

1.4

1.4

1.4

1.6

1.7

1.8

Unemployment rate (%)

4.0

4.0

3.8

3.8

3.9

3.7

3.7

3.7

3.7

3.7

Fiscal balance (% of GDP)

-3.5

-3.6

-4.0

-4.1

-4.3

-4.4

-4.4

-4.5

-4.7

-4.6

*PCE Price Index

All opinions and claims are based upon data on 9/16/19 and may not come to pass. This information is subject to change at any time, based upon economic, market and other considerations and should not be construed as a recommendation. Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect. Source: DWS Investment Management Americas Inc.

CRC 070573 (09/2019)

1. https://www.chicagofed.org/publications/chicago-fed-letter/2018/404

2. Higher real rate premium and higher demand for shorter dated maturities.

3. Since around the end of 2014, here e.g. https://fred.stlouisfed.org/series/T5YIFR

4. https://www.newyorkfed.org/research/data_indicators/term_premia.html - decompositions of the term premium are rather rare and mostly not up to date.

5. https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp2033.en.pdf

6. https://www.federalreserve.gov/newsevents/pressreleases/monetary20180822a.htm

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