Weird times in the bond market

Few statements strike fear into the hearts and minds of investors as those three ominous words: “yield curve inversion.” When the yields of bonds with longer maturities are lower than those with shorter time horizons, there is a reasonable chance that a Recession is on the way — at least according to data going back many decades. As always, though, there are caveats to the “reversal and therefore stagnation” logic. False positives have occurred, most recently when the 10-year and 2-year Treasury bonds reversed briefly in September 2019. This fleeting reversal was actually followed by a recession in March 2020, but this recession was a deliberate decision to shutdown completely. On the basis of an event that no one knew anything about in September 2019.

And you, six-month-old Bill?

False positives aside, the current shape of the yield curve really does look as if the bond market is anticipating a recession in the not-too-distant future. Not only the two-year term, but the one-year Treasury bill and even the 6-month Treasury bill are now inverted to the 10-year denomination. 6 months was on par with 10 years based on yesterday’s close (see chart below) but in early trading today, the 6 month yield was 2.86 per cent versus 2.77 per cent for the 10 year bond.

Interestingly, the compression into longer maturities has had a mostly positive effect on the stock market this week, particularly the growth-oriented parts of the market that benefit the most from lower interest rates. The 10-year treasury is widely used as a benchmark for calculating a company’s cost of capital, so when that rate goes down, the company’s value goes up. Over the past several weeks, growth stocks, which suffered the brunt of the stock market slump earlier this year, have outperformed their value stocks peers by a large margin.

It’s worse elsewhere

However, part of the interpretation of the inverted curve may have nothing to do with any possibility of recession and has much to do with the fact that things in other parts of the world are worse than they are here at home. The US dollar has risen sharply against other major currencies, including the euro, sterling and Japanese yen, at times to levels not seen in more than 20 years. A strong dollar increases the attractiveness of US assets. Medium and long-term treasury bonds are an essential asset of central banks and foreign financial institutions.

In fact, one of those “false positive” moments for inverted yield curves occurred during yet another case of monetary tightening by the Federal Reserve. In 2006, then-Fed Chairman Ben Bernanke expressed bewilderment as to why the 10-year yield was lower than those with shorter maturities. The chart below is an exact copy of the chart above for January-December 2006, and you can see that the reversal continued into the better part of the second half of that year.

The answer to Bernanke’s confusion turned out to be the massive demand for US medium and long-term Treasuries by foreign institutions, chiefly the Chinese Central Bank for the purposes of foreign exchange reserves. Today, with China on a seemingly permanent lockdown for Covid, Europe dealing with a whole palette of social, political and economic crises, and threats of more emerging market debt defaults similar to Sri Lanka, the case for US Treasuries will also sound strong.

Maybe yes, maybe light?

The probability of some flavor of stagnation in the next six months is almost certain to be north of zero and possibly even north. But there is almost nothing in the current batch of macroeconomic data to suggest that if one were to happen, it would be of the painful kind like 1980 or 2008. The most likely comparison would be 2001, when the economy was technically in a recession for eight months but didn’t see Even two consecutive quarters of negative growth. A mild stagnation may be the price to pay for lowering inflation. It would be better, for example, to avoid a full recession but live with a prolonged period of slow growth and high inflation similar to the 1970s.

And that outcome may, in fact, be what the bond market is signaling. Credit risk spreads between Treasuries and securities of investment-rated companies have risen slightly in recent weeks but are still below their three-year average, indicating that there is no concern that a wave of corporate default is imminent. We’ll see more pieces of the puzzle coming together in the coming weeks with the release of Q2 GDP and the bulk of earnings reports from key S&P 500 components. For now, however, the odd shape of the yield curve doesn’t tell us to run for the hills.

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