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Message from the bond market

 Salomons Judgement

An inverted yield curve is an indication of a recession, that’s a natural law for me. Or is it really different this time?

The yield differential between long-term and short-term US bonds continues to fall. The chance of an inverse term structure of interest rates increases. Just like in the past, this causes an enormous discussion about what the message is. Is it the harbinger of a recession? Should investors sell off? It’s still too early for that, but it’s good to look at the past.

In my lectures I always show this historic development of the American yield curve. 2007 was the last time that the difference in yields between a ten- and a two-year bond was this low. Just like then, this is mainly driven by central banks raising interest rates. Although bond yields have risen in sympathy, that back up is still rather limited. So far, yields on two-year bonds in this Fed rate hiking cycle are up by 130 basis points. In earlier times, short-term yields increased much faster. The same also applies to the ten-year yields. These also tend to rise more.

The yield difference between long-term and short-term Treasuries is now slightly less than 0.25%. Let us recall that in 2008 it was about 3%. And in 2013 it was a full 2%. The flattening of the curve started in 2017, when the Fed started to increase interest rates. If the Fed keeps increasing rates by a quarter per quarter, then an inverted curve is almost certain at the end of this year or the beginning of 2019. It just depends on the bond market reaction.

Let there be no misunderstanding: an inverse yield curve is cause for concern. Every time the curve reversed, it led to a recession and a considerable correction in the stock markets. Based on all recessions since 1960, the average time frame between an inverse yield curve and the peak in the stock market is ten months. The time between the peak in the stock market and the beginning of the recession is five months on average. Hence, the total average of months between an inverse curve and a recession is 15. Sometimes things go faster, as in 1973 when it took nine months. Or slower, like the 25 months in 1970.

The question is whether these lessons apply in the current situation. As a result of an unconventional central banking policy, other laws would apply. To me that sounds like “this time it’s different”. Ten years ago, long-term interest rates fell as a result of the global savings glut: too much savings and too little investments. It’s really different now. Right ... To me, an inverted yield curve is an indication of a recession. It might take a bit longer than 15 months, but it can also be shorter.

I save the most important figures for last. The average loss equity investors face from peak to trough following a yield curve inversion is – 39%. And the two most recent examples were even worse as valuations were too high and/or systemic risk prevailed. It won’t be that bad. The other ‘good news’ is that it will take a while. It’s a matter of timing. It’s still too early. As a rule of thumb I’d use mid 2019 as the peak in markets. Or would the message really be different this time?

The author

Roelof Salomons

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