Yield curve and credit spreads signal low US recession risk

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1 = Yield curve and credit spreads signal low US recession risk Many market participants are fearful that the narrowing gap between the yield on the 10-year and 2-year Treasury notes signals that the US economy may tip into recession as early as sometime in But a better guide to recession risk is the short-maturity yield curve and risk appetite in the corporate credit market. The message from short-term interest rate expectations and the credit market is that the risk of a recession over the next year is low. The US business and credit cycle is aged but is likely to live longer than many expect. Published August 2018 Author David Riley Chief Investment Strategist

2 Inversion of the Treasury yield curve yields on short-term Treasury notes above those on long-term Treasury securities preceded virtually every recession since the 1950s. An inversion of the yield curve does not cause a recession, but rather reflects investors expectations of an economic downturn that will prompt the Fed to begin to cut interest rates at some point over the next several quarters. The measure of the yield curve most commonly referenced by market participants is the difference between the yield on the 10-year and 2-year Treasury notes. The yield curve on this measure currently stands around 30bps (0.3%), the lowest level since the end of the last recession. With the Fed signalling further interest rate hikes, many commentators predict that the 2s-10s curve will soon invert signalling a pending recession that will bring the current expansion, the second longest in the post-ww2 era, to an end. 1 But there are other, more relevant, measures of the slope of the yield curve that are not so close to inversion and imply that near-term recession risk remains low. The New York Fed uses the difference between 10-year and 3-month Treasury rates to derive the probability of a recession twelve months ahead. Based on latest monthly data for July 2018, the probability implied by the 3mth10yr curve that the economy will be in recession in July 2019 is 13.6%, less than the unconditional recession probability of around 17% (in the post WW2 era, on average the US has been in recession one year in six). 1 However, market expectations of future Fed rate hikes are already reflected in the yield curve and thus a few more 25bps Fed rate hikes will not necessarily lead to inversion.

3 A recent econometric analysis by Fed staff concluded that the near-term forward spread the difference between the 3-month Treasury current (or spot) rate and the market-implied rate six-quarters ahead is a much more accurate predictor of recession than the 2s-10s curve. 2 The near-term forward spread is much more sensitive to shifts in the near-term economic outlook as reflected in shifts in expectations for Fed monetary policy than the 2s- 10s curve (see Fig. 3). Since late summer of 2017, the near-term forward spread steepened in response to the boost to US economic growth from tax cuts and Fed forward guidance on rates even as the 2s-10s curve has continued to flatten (the 10-year Treasury yield also incorporates global investor demand for yield and safe assets as well as the legacy of QE). 2 (Don t Fear) The Yield Curve, FEDS Notes, US Federal Reserve, June 28, 2018

4 The forward-looking nature of the yield curve means that it is a better predictor of recession than current economic data ( hard such industrial production or soft such as business surveys). Credit spreads are also a forward-looking indicator that captures information about investor expectations for future economic activity. A Fed staff measure of investor sentiment or risk appetite in the corporate bond market is the excess bond premium the additional spread that is not directly attributable to firm-specific expected default risk. 3 An increase in the excess bond premium may reflect investors raising their assessment of recession risk. A model of the probability of recession at some point over the next 12 months based on the excess bond premium is shown in Fig. 4 with a current probability of 12%. It is interesting to note that the credit market also gave false positives predictions of recession that did not occur in 2002 associated with the accounting scandals and bankruptcies of some large firms (notably Enron) and in 2016 on the back of a surge in commodity-related defaults and fears of a China hard landing. 3 Recession Risk and the Excess Bond Premium, FEDS Notes, US Federal Reserve, April 8, 2016

5 The probability of a recession starting at some point over the next four quarters using a model developed by BlueBay that includes both the near-term forward spread and the excess bond premium is illustrated in Fig. 5. A positive feature of the model is that it provided a better signal of rising recession risk prior to the last recession that started at the beginning of 2008 than the other models (it has a better fit with a pseudo R 2 of 0.5). But compared to yield curve based models solely, it also sends more false warning signals reflecting episodes of risk aversion in the credit market. Nonetheless, current values of the near-term forward and excess bond spreads imply that recession risk is low and actually fell in the first half of 2018.

6 Using forward-looking financial variables the yield curve and credit spreads implicitly assumes that markets are rational in the sense they appropriately capture all the available and relevant information. Yet history is replete with financial bubbles and subsequent crashes that reflect investor behaviour that proved to be far from rationale. Nonetheless, market expectations for short-term interest rates and current credit spreads suggest that the near-term (1-year) risk of recession is low despite the flattening of the 2s-10s curve that has garnered so much attention. The US expansion is one of the oldest, but also the least spectacular in terms of cumulative economic growth (even with the recent acceleration). Be wary of warnings that the yield curve is signalling a pending recession - It is too soon to ready portfolios for a US economic downturn.

7 Disclaimer This document is issued in the United Kingdom (UK) by BlueBay Asset Management LLP (BlueBay), which is authorised and regulated by the UK Financial Conduct Authority (FCA), registered with the US Securities and Exchange Commission, the US Commodity Futures Trading Commission (CFTC) and is a member of the National Futures Association (NFA). This document may also be issued in the United States by BlueBay Asset Management LLC which is registered with the SEC and the NFA. Past performance is not indicative of future results. Unless otherwise stated, all data has been sourced by BlueBay. To the best of BlueBay s knowledge and belief this document is true and accurate at the date hereof. BlueBay makes no express or implied warranties or representations with respect to the information contained in this document and hereby expressly disclaim all warranties of accuracy, completeness or fitness for a particular purpose. This document is intended for professional clients and eligible counterparties (as defined by the FCA) only and should not be relied upon by any other category of customer. Except where agreed explicitly in writing, BlueBay does not provide investment or other advice and nothing in this document constitutes any advice, nor should be interpreted as such. No BlueBay Fund will be offered, except pursuant and subject to the offering memorandum and subscription materials (the "Offering Materials"). If there is an inconsistency between this document and the Offering Materials for the BlueBay Fund, the provisions in the Offering Materials shall prevail. You should read the Offering Materials carefully before investing in any BlueBay fund. This document does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product in any jurisdiction and is for information purposes only. No part of this document may be reproduced in any manner without the prior written permission of BlueBay Asset Management LLP. Copyright 2018 BlueBay, the investment manager, advisor and global distributor of the BlueBay Funds, is a wholly-owned subsidiary of Royal Bank of Canada and the BlueBay Funds may be considered to be related and/or connected issuers to Royal Bank of Canada and its other affiliates. Registered trademark of Royal Bank of Canada. RBC Global Asset Management is a trademark of Royal Bank of Canada. BlueBay Asset Management LLP, registered office 77 Grosvenor Street, London W1K 3JR, partnership registered in England and Wales number OC

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