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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
There is always a point in working out a whodunnit where a half-forgotten fact resurfaces to complicate the evolving theory. There is a similar pattern developing in the current investor narrative of the US economy with a much-watched phenomenon in the bond markets the candidate for the awkward point.
There is rising confidence in a US economic soft landing but a classic recession-predictor in markets is still flashing red — the so-called inversion of the yield curve.
Normally, the longer the term of a bond, the higher the yield as investors seek compensation holding the debt at a greater time and the extra risk that entails. When the yield curve inverts, yields on short-term bonds rise above longer-term ones. It has been seen as a harbinger of bad economic times because it implies expectations that interest rates will be lowered in the longer term to stimulate growth.
Are investors missing something or is it this time a red herring? Few issues in markets can have consumed more little grey cells, to use Hercule Poirot’s favourite phrase, than debating why the yield curve predicts downturns and exactly what it is signalling when it does it.
There are different measures of the curve but the most popular is the gap between two- and 10-year yields, which have been inverted since July 2022. At the deepest point of inversion in July last year, 10-year notes offered 3.9 per cent, against almost 5 per cent for two-year debt. This week the gap shrank as low as 0.15 percentage points but still remains inverted. And regardless of the precise curve being measured, this current inversion over 19 months and counting is the longest since the early 1980s.
Why the inverted yield curve signals a recession — or doesn’t — depends on who you ask. An inversion has preceded every recession in the past 60 years and only sent a wrong signal through inverting once, in 1965, according to a 2018 paper by economists for the Chicago Federal Reserve.
So far so clear, but then the Fed’s team got to the bigger mystery, adding “while the literature has found predictive content . . . it has been less successful at establishing why such an empirical association holds”.
Some view the inverted curve as a simple signalling device of market expectations. For others though, the inversion adds to the problem itself.
“A positive sloping yield curve promotes animal spirits . . . lending, and all things that are usually growth positive,” says Jim Reid of Deutsche Bank. He argues that when yield curves are inverted, banks tend to tighten lending standards and investors can be more defensive, simply locking in higher yields with short-term bonds rather than taking a longer-term bet.
One thing that holds true for every curve inversion is an accompanying debate about whether this time is different. In 2000, it was deemed crazy to think of a downturn when the shares of new and economically disruptive tech companies were soaring. When the curve flipped in 2006, global Treasury bond buying patterns were considered the technical cause as China recycled its export dollars into US debt. That appeared to have little link to any impending recession, but by keeping yields lower, it arguably helped fuel the reckless lending that produced the 2008 financial crisis.
This time Washington’s pandemic spending is the blame candidate, having distorted economic and investment behaviour that could have shaken or at least delayed the yield curve’s predictive power.
With consumer spending so buoyant, how could a recession be lurking? Well, there is typically a time lag between inversion and an economic downturn. JPMorgan strategists say the risk of a recession is highest between 14 and 24 months after inversion based on previous instances. That covers the first half of 2024 at least.
Brett Nelson, of Goldman Sachs’s investment strategy group, also points out: “It also matters for how long any given yield curve is inverted, with longer inversions being more meaningful than shorter ones.”
Goldman’s ISG team, however, has dropped its probability of recession this year to 30 per cent, from 45-55 per cent in 2023.
Fictional detectives produce clean, clear and correct solutions to the mysteries they face. Economies and financial markets, less so. Perhaps the way to conclude the yield curve puzzle is to remember that a soft landing does not necessarily preclude a shallow recession.
The five-plus quarter-point interest rate cuts currently being priced in by investors imply something potentially more painful. Otherwise, why would the Fed slash rates so speedily without a rapidly weakening economy to rescue? A gradual slowdown is certainly a simpler story, but it still does not quite account for all the facts.