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Roula Khalaf, editor of the FT, picks her favorite stories in this weekly newsletter.
In crafting a crime story, there is always a point at which a half-forgotten fact resurfaces and complicates the evolving theory. A similar pattern is emerging in the current investor narrative about the U.S. economy, with a much-watched phenomenon in bond markets as the candidate for the sticky point.
There is growing confidence in a soft landing for the US economy, but a classic recession indicator in markets is still flashing in the red – the so-called yield curve inversion.
Typically, the longer the term of a bond, the higher the return, as investors seek compensation by holding the debt for a longer period of time and taking on the additional risk that comes with it. When the yield curve inverts, yields on short-term bonds rise above those of longer-term bonds. It is seen as a harbinger of bad economic times because it brings with it expectations that interest rates will be cut in the longer term to stimulate growth.
Are investors missing something or is it a red herring this time? Few market issues can take up more brain power, to use Hercule Poirot's favorite expression, than the debate over why the yield curve predicts downturns and exactly what it signals when they do.
There are various measures of the curve, but the most popular is the gap between two- and 10-year yields, which has been inverted since July 2022. At the bottom of the reversal in July last year, 10-year bonds were offering 3.9 percent, versus nearly 5 percent for two-year debt. This week the gap shrank to just 0.15 percentage points, but is still reversed. And regardless of the exact curve measured, this current 19-month-plus inversion is the longest since the early 1980s.
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Why the inverted yield curve signals a recession – or not – depends on who you ask. Over the past 60 years, every recession has been preceded by a reversal and only once, in 1965, did the reversal send a false signal, according to a 2018 paper by economists at the Chicago Federal Reserve.
So far so clear, but then the Fed team got to the bigger puzzle, adding: “While the literature has found predictive content. . . it has been less successful in determining why such an empirical relationship holds.”
Some view the inverted curve as a simple signaling tool for market expectations. For others, however, the reversal exacerbates the problem itself.
“A positively sloping yield curve promotes animal spirits.” . . Lending and everything that normally promotes growth,” says Jim Reid of Deutsche Bank. He argues that when yield curves are inverted, banks tend to tighten lending standards and that investors can be more defensive by simply locking in higher returns with short-term bonds rather than making a longer-term bet.
One thing that is true of every corner reversal is an accompanying debate about whether this time is different. In 2000, it was considered crazy to think of a downturn when stocks of new and economically disruptive technology companies were soaring. When the curve inverted in 2006, global government bond buying patterns were seen as a technical cause as China converted its export dollars into U.S. debt. That seemed to have little to do with an impending recession, but by keeping yields lower it arguably helped fuel the reckless lending that triggered the 2008 financial crisis.
This time, Washington's pandemic spending is the culprit, distorting economic and investment behavior that could have shaken or at least delayed the yield curve's predictive power.
With consumer spending so buoyant, how could a recession lurk? Well, there is usually a time lag between the reversal and an economic downturn. JPMorgan strategists believe the risk of a recession is highest between 14 and 24 months after the reversal, based on previous cases. That covers at least the first half of 2024.
Brett Nelson of Goldman Sachs' investment strategy group also points out: “How long a given yield curve is inverted also matters, with longer inversions being more meaningful than shorter ones.”
However, Goldman's ISG team has cut the probability of a recession this year to 30 percent, from 45 to 55 percent in 2023.
Fictional detectives find clean, clear, and correct solutions to the mysteries they face. Economies and financial markets less so. Perhaps the yield curve puzzle can be solved by considering that a soft landing does not necessarily preclude a shallow recession.
The more than five-quarter percent interest rate cuts currently priced in by investors point to something potentially more painful. Why else would the Fed cut interest rates so quickly without a rapidly weakening economy to save them? A gradual slowdown is certainly a simpler story, but it still doesn't explain all the facts.
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