Why yield curve inversion is different this cycle

Instead of recession, find out what inversion might signal

Certain U.S. yield curves have inverted recently—a potential early warning sign that recession could be a year or so away. However, in the current cycle, inversion might be signalling something different to investors.

Last month saw the inversion of U.S. ten-year and three-month Treasurys, and the Canadian 10-year yield dropping below the Bank of Canada’s overnight rate.

Instead of portending a recession, the yield curve might be indicating that markets expect central banks to “ease policy enough to keep the cycle going” as global growth slows, said CIBC chief economist Avery Shenfeld in a report.

Shenfeld first explained why inversion is different this cycle. In most historical cases of recession, short rates must be quite elevated to surpass longer-term yields, but that’s not true for this cycle because longer rates are now at a “lower normal,” he said.

That new low reflects a lighter volume of capital spending, bond buying by central banks under quantitative easing and regulatory demands for institutions to hold safe assets, Shenfeld said in the report. Further, decades of tame inflation have subdued investor fear of any inflation upside, he said, reducing the risk of investing in bonds at modest nominal yields.

“With longer rates anchored, we need less drama in short rates to invert the curve,” he said.

As such, inversion indicates that markets see enough signs of slowdown in economic growth to bet on central bank rate cuts. “Anyone buying a mid-term bond at a yield below a three-month bill is doing so under the assumption that three-month rates are set to fall,” Shenfeld said.

CIBC forecasts a Fed rate cut in 2020 when fiscal stimulus ends. In Canada, the central bank is less likely to cut rates (assuming a single Fed rate cut), considering the Bank of Canada didn’t hike rates as much as the Fed to being with, Shenfeld said. However, a series of Fed cuts would likely result in challenges for exporters as the Canadian dollar firmed, potentially causing the Bank of Canada to cut rates as well.

Portfolio positioning

In a report, HSBC Global Asset Management says it’s not changing its multi-asset investment view, which tilts toward risk assets, as a result of curve inversion.

It says the trigger for U.S. curve inversion last month was weaker-than-expected German manufacturing data, published at a time when investors were already nervous given slower global growth and the sharp rally in risk assets at the beginning of the year. That weakness in the eurozone was extrapolated to the global economy—but incorrectly so, HSBC says.

“Modest but acceptable growth, a lack of broad-based inflation pressures and dovish global monetary policy implies to us a relatively constructive environment for risk assets,” the report says. That outlook, along with global equities that are fairly valued, supports the asset manager’s stance to maintain its overweight position on equities in multi-asset portfolios.

Within fixed income, HSBC says it remains underweight government bonds, which reflect poor valuations. For example, 10-year bond yields are below zero and 10-year Treasury yields recently hit their lowest in more than a year.

For full details, read the HSBC report and CIBC report.