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Fixed-Income Insights

We answer additional investor questions about the potential economic implications of the March 22 inversion. 

 

In Brief

  • The inversion of the three-month/10-year U.S. Treasury curve on March 22, 2019, continues to prompt questions from investors about whether it is signaling an imminent U.S. recession.
  • We have previously noted that a number of predictive economic indicators do not suggest that an economic downturn is near. Here, we take a closer look at some additional factors.
  • Based on an examination of the timing of previous inversions, the effect of U.S. financial conditions on recession probability, and the low-yield environment of the past several years, we reiterate our view that a near-term U.S. recession remains unlikely.

 

A recent Market View by Lord Abbett investment strategist Tim Paulson discussed the potential implications for the U.S. economy from the inversion of the three-month/10-year U.S. Treasury yield curve on March 22, 2019. Based on the strong reader response to that article, and further questions from investors about the implications of this development, we will explore additional dimensions of the curve inversion and its potential impact on the U.S. economy.

But first, a recap. On March 22, the yield on three-month U.S. Treasury bills exceeded that of the 10-year U.S. Treasury note, the first time the curve had inverted since the 2008–09 financial crisis. (The 3-month/10-year spread subsequently moved back into positive territory—de-inverting, if you will.) Given the fact that a yield curve inversion has preceded each of the last seven recessions, some investors have become concerned that the decade-long U.S. economic expansion is close to ending. However, we would point to three factors that we believe should mitigate investor fears of near-term recession:

1. After inversion, how long does it take for a recession to kick in?
Bloomberg research shows that since the late 1970s, the interval between the first occurrence of an inverted 2-year/10-year Treasury yield spread and a recession has ranged from 293 days to 1,073 days, averaging 627 days. Looking at the two most recent inversions (prior to the March 22 occurrence) included in their study—the ones beginning March 24, 1998, and December 27, 2005—it took roughly three years (1,073 days) and two years (704 days) from inversion, respectively, before a recession occurred. In those periods, the S&P 500® Index returned 12% and 17%, respectively. (See Chart 1.)

 

Chart 1. The Five Times U.S. Recessions Have Followed Curve Inversions Since 1978
Inversion date and number of days until start of next recession

Source: Bloomberg. Data covers the period January 1, 1975–March 22, 2019. Inversion depicted for March 22, 2019, occurred in the three-month/10-year U.S. Treasury curve.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

 

So yes, a recession may follow the March 22 yield curve inversion at some point. Given that the ultimate timing remains a mystery, those who orient portfolio decisions focus solely on when the next downturn is coming may wind up missing out on investment opportunities while they wait for the recessionary shoe to drop.

2. What are other recession predictors telling us?
In his recent article, Paulson pointed out that both the Chicago Fed National Activity Index1 and the Philadelphia Fed Diffusion Index2 are indicating a positive outlook for economic activity. Meanwhile, the Index of Leading Economic Indicators for February actually suggested that growth was poised to pick up. What’s more, the Chicago Fed National Financial Conditions Index (NFCI),3 an indicator of financial stress and tightness of credit markets, is suggesting that U.S. financial conditions are highly accommodative.

That inspired us to dig a little deeper into the inversion/recession relationship. Jeffrey Herzog, Ph.D., a portfolio manager for Lord Abbett’s multi-asset class strategies, notes that when looking at the yield curve in a vacuum, the statistical probability of a recession does tick higher; however, when pairing it with what the NFCI is telling us, the risk of a downturn decreases (see Chart 2).

 

Chart 2. Recent U.S. Financial Conditions Appear to Lower Probability of Recession
Recession probability of the U.S. Treasury curve (three-month/10-year) with and without adjustment for underlying U.S. financial conditions, January 1975–March 2019

Source: Bloomberg, U.S. Federal Reserve Bank of Chicago, and Lord Abbett. U.S. financial conditions are represented by the Chicago Fed National Financial Conditions Index (NFCI), an indicator of financial stress and tightness of credit markets. Chart displays the standard recession probability regression with (1) the 12-month lag of the yield curve slope (three-month/10-year) and (2) a version that incorporates that slope and the one-month lag of the NFCI.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

 

Here is a review of some of the factors that are currently supportive of U.S. economic growth:

  • A healthy labor market, including first-time unemployment claims near 50-year lows and strong job and real income growth;
  • a more dovish U.S. Federal Reserve (Fed), which has indicated it will not hike rates for the rest of 2019;
  • highly accommodative financial conditions;
  • non-manufacturing purchasing-manager sentiment data that remains consistent with above-potential gross domestic product (GDP) growth;
  • corporate aftertax profits that remain near record highs;
  • steadily increasing U.S. business capital spending; and
  • more positive sentiment surrounding U.S.-China trade talks and Chinese growth.

3. How might the low-yield environment of the past few years factor into the recent inversion?
A combination of low inflation premiums, low volatility, the expansion of global central bank balance sheets, and demand for U.S. Treasuries from foreign investors has put downward pressure on intermediate-term yields. So much so that the term premium, the compensation investors require for holding a long-term bond in lieu of rolling over a series of short-term bonds, is negative. Essentially, that is telling us that investors in longer-term bonds are not being compensated for the uncertainty associated with the level of future interest rates. Low longer-term yields, paired with higher short-term yields driven by Fed rate hikes, lead to a flatter yield curve. Under these circumstances, the hurdle for inversion of the U.S. Treasury curve was much lower than in past cycles.

Summing Up: We Believe the Risk of an Imminent Recession Remains Low
We would argue that the factors we have detailed here do not signal an imminent recession. Obviously, the decade-long U.S. expansion will come to an end at some point in the future, but drawing a bead on the exact timing of such an occurrence is notoriously difficult. In the meantime, we believe that there continue to be attractive opportunities for active managers within both fixed income and equity markets.

--Timothy Paulson, Investment Strategist, and Emma Rudnik, Product Consultant, contributed to this article

 

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