The yield curve and the next recession

Get recession-ready by monitoring yields and corporate spreads

Investors who are anxious about the next recession should stay ahead of the curve—the yield curve, that is.

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“The shape of the yield curve is one of the best predictions of recessions,” said Patrick O’Toole, vice-president of global fixed income at CIBC Asset Management. He finds that the bond market is a good predictor of economic growth.

A normal, or steep, yield curve is present when shorter-term rates are low relative to longer-term rates, and that typically indicates economic growth will continue and inflationary pressure will rise. To compensate investors for the potential of rising inflation, longer-term bond yields are generally higher, said O’Toole during a late-August interview.

A normal yield curve is usually followed by a flatter curve, as central banks raise rates in an attempt to ease inflationary pressure.

Action from the central bank “usually means economic growth is around what is considered potential […] without the worry that inflation will accelerate,” said O’Toole, who co-manages the Renaissance Canadian Bond Fund, an underlying fund in the Renaissance Optimal Income Portfolios. “It’s like the goldilocks scenario: the economy and inflation are both running not too hot or not too cool; everything’s just right.”

With a flatter yield curve, investors in long-term bonds also don’t demand higher yields as compensation for inflation risk, he added.

In contrast, an inverse yield curve results when central banks aim to reduce inflation aggressively by raising short-term rates above long-term rates. “When you get that inverse curve, that’s generally been a good indicator that a recession is imminent,” said O’Toole.

Tracking the curve like a pro

To get ahead of a potential inverse curve, O’Toole monitors the yield spread between the three-month Treasury bill and 10-year Treasury bond (research from the Federal Reserve Bank of San Francisco recently called this “the best summary measure” for forecasting a recession).

“When that T-bill yield has gone higher than the bond yield for 10 consecutive days, what we’ve seen in the past is a recession has occurred on average about 310 days later,” O’Toole said, referencing data from the last seven recessions. That average represents a range of between roughly 100 and 400 days before the recession occurs, giving investors time to prepare, he added.

As of Sept. 10, the spread between the three-month T-bill and 10-year bond was 80 basis points or 0.8%, with a similar spread in Canada. “For now, the bond market isn’t flashing a warning sign about a recession,” said O’Toole.

“But keep in mind that that spread was near 3% at the end of 2013, it was just below 1% at the end of last year, and now it’s at that three-quarters of a per cent or 75 basis points,” he said. “And that’s telling us that growth isn’t expected to stay strong, and that inflation isn’t likely to be a problem.”

While current economic indicators point to signs of a late business cycle—the job market’s expected to slow, there is some inflationary pressure, and mergers and acquisitions activity is ample—business cycles typically end when central banks tighten monetary policy too aggressively, said O’Toole.

“The bond market isn’t overly worried about that yet, where we’re sitting today,” he said.

Bide your time, until it’s time to buy

Still, investors want to know if it’s time to get defensive with corporate bonds.

Corporate spreads, or “that extra yield that investment grade corporate bonds offer over top of Government of Canada bond yields,” have ranged from 1% to 1.5% over the last few years, O’Toole said. In late August, the spread was about 1.15%.

In 2007, before the financial crisis, he said the spread was less than 75 basis points, or 0.75%, while it was more than 400 basis points, or 4%, at the height of the financial crisis in 2008-09.

That historical context makes today’s spread “OK,” said O’Toole. Though corporate bonds aren’t cheap, “the compensation that they offer is fair, given the economic outlook and the risks of default,” he added.

He expects corporate bond returns to continue to beat those of government bonds in the next year, but he cautions investors to temper their expectations. “Don’t expect the same level of outperformance that you’ve seen over the past few years,” he said.

He hasn’t taken a defensive position in his portfolio yet, but he’s reduced risk “somewhat, given we could see some hiccups in the world that could cause flight to quality trade,” he said.

If investors rush to the safety of government bonds as volatility increases, he added, “that would offer an opportunity to us to buy corporate bonds at a cheaper level. We’re going to wait for that opportunity, and make sure we have some ammunition to add if the opportunity does present itself.”

Also, even though a recession isn’t part of his base-case scenario, “there’s no doubt we are late stage in this cycle and the risk is higher today than it was two, three years ago,” he said.

This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.