From the back rooms of bond research departments comes the disheartening news that the yield curve for U.S. Treasury bonds is flattening and could invert next year, causing a kink where rates rise for a while and then drop. Somewhere between one day and 30 years, which is the usual span of the curve, the up would stop and the down would start. That is the kink and it is a warning that recession and falling stock prices are to come.
Normally, the curve rises gently from one day to 30 years, reflecting inflation expectations. If the yield-to-time relationship drops, it means several things: one, that there will be less inflation ahead. Moderate inflation is associated with economic growth. So no curve rise or even a drop means less growth or no growth and stagnation or recession to come. What’s more, after a fairly sustained rise since the end of the mortgage meltdown crisis of 2008-09 and the correction at the start of 2016, it’s time stock markets, many at all-time highs, take a break and reset. A collapsing curve of government bond yields would precede that event.
American investment bank Morgan Stanley recently told its clients that the U.S. Treasury yield curve would go flat in the third quarter of 2018 with the 10-year Treasury bond hitting a record low of two per cent.
Flattening to inversion
There is evidence that the process of flattening going to inversion is underway. Stock prices are high because interest rates are low. People take risk on stocks rather than holding safe government bonds because bond payouts are so crummy. A yield curve inversion would, however, tell people to take cover, sell stocks, and accept even lower bond returns. That would, in effect, be insurance against worse to come. Federal government bonds may be a poor way to earn income, but they never default.
A yield curve kink indicates two things: From the investor’s point of view, it’s evidence of people buying shelter through lower bond yields and accepting the cost in terms of lower returns. From the point of view of companies that sell bonds to raise money, it shows precaution for they borrow less and thus offer lower interest rates.
Where government bond yields go, corporate bond yields follow. It is worth noting that yield curve inversion, that is, the point where the curve stops going up and starts to head down, has predicted every North American recession in the last half century.
The inversion may be coming, but it will take at least some months. The main player is the Federal Reserve Board. For flattening or inversion to happen, the Fed has to push up short-term rates above present 10-year rates at least. That would mean that the three-month U.S. Treasury yield, now about 1.25 per cent, and Canada’s as well at one per cent would have to rise to two per cent. That’s not in immediate sight, but it could happen next year. If T-bond buyers prefer to go long and lock in money ahead of the dropping long rates that are part and parcel of a recession in combination with rising short rates, the kink would happen.
How sure a thing is the inversion? No one knows what the American administration may do. Uncertainty is itself a reason to buy Treasury debt, especially long debt to lock up money safely until the fog clears.
“The Fed has been wanting to raise rates for a couple of years and if it does, its overnight rate would rise from today’s effective rate of about 1.4 per cent by 1.6 per cent to three per cent. That would take at least a few meetings of the Fed’s rate-setting Open Market Committee,” says Edward Jong, vice president and head of fixed income at TriDelta Investment Counsel Inc. in Toronto. “We think that the Fed would be smart enough not to cause an inversion. Moreover, rising inflation is not yet a concern.”
What to do? Investment decisions based on political forecasts are dicey. Precaution suggests lightening up on stocks because markets are high. The potential of a yield curve inversion adds to the incentive to move to 10-year Canada or U.S. bonds for a recession that may yet happen. A yield curve kink is part of most recessions, but the timing remains uncertain. But the post-2008 to 2009 boom, which withered in 2015 and then restarted in early 2016, is almost a decade old. A stock market reset heralded by a kink in the government bond yield curve would just be part of the process.