YIELD CURVE INVERSION: A CLEAR BUT UNLIKELY DANGER

Transcription

1 1-year minus -year UST (%) INVESTMENT STRATEGY COMMENTARY YIELD CURVE INVERSION: A CLEAR BUT UNLIKELY DANGER December 4, 17 Investors focus on the yield curve with good reason an inverted curve has historically led to recession and eventual stock market losses. However, we don t believe the Federal Reserve will put us in this position, and expect continued risk asset gains. With short-term rates rising but long-term rates remaining low, investors are growing increasingly worried over the potential for a yield curve inversion. However, the current curve is further away from inversion than the headlines suggest. The -1 spread (1-year minus - year U.S. Treasury yields) is currently at.6%, as compared with its 1.% historical average (see Exhibit 1). Also, while yield curve inversions do generally occur ahead of stock market declines (defined here as a next 1-month negative S&P 5 price return), these stock market declines take time to materialize. Of the four major yield curve inversion occurrences over the past 4 years, only once did the inversion coincide with a sustained stock market decline during the dot-com era of the early s. Other than the dot-com bust, stock market declines did not start for anywhere between six months to two years after the yield curve inverted, responding to the recessions that inverted curves have always preceded. Generally, central banks cause yield curve inversions through rate hiking campaigns, which are usually prompted by inflationary pressures. We don t have inflationary pressures today and don t expect them to materialize over our forecasting horizon. What we do have today is a large number of bonds yielding negative interest rates around the world. This is challenging the Fed s plan to gradually reduce easy monetary policy, as low global rates are capping longer-dated U.S. Treasury yields (over which the Fed has less control). The Fed is aware of the problems historically presented by an inverted yield curve and thus, absent inflationary pressures, we believe the Fed will seek to avoid it. Why would the new Fed leadership want to be blamed for unnecessarily inverting the curve and potentially causing the next recession? Northern Trust Investment Strategy northerntrust.com/ investmentstrategy James D. McDonald Chief Investment Strategist jxm8@ntrs.com Daniel J. Phillips, CFA Director, Asset Allocation Strategy dp61@ntrs.com EXHIBIT 1: IT TAKES TIME FOR INVERSIONS TO HIT STOCKS YIELD CURVE SPREAD AND STOCK MARKET DECLINES Dec-77 Dec-83 Dec-89 Dec-95 Dec-1 Dec-7 Dec-13-3 Stock market declines 1-year UST yield minus -year UST Average spread Source: Northern Trust Investment Strategy, Bloomberg. Monthly data: 1/31/1977 through 1/31/16. Stock market declines represent periods of negative 1-month S&P 5 returns. Note: UST = U.S. Treasury. 1

2 Yield spread (%) S&P 5 1-month price return (%) S&P 5 1-month price return (%) INVESTMENT STRATEGY COMMENTARY An inverted yield curve has reliably signaled that a stock market decline is on its way. However, because of the varying lags involved between when the yield curve inverts and when the stock market actually sells off, the pure data shows no correlation between yield curve steepness and subsequent stock market returns. Looking at the left-hand chart in Exhibit, the yield curve has been inverted in 68 of the 466 month-end data points since Of those 68 data points, the next 1-month return for the S&P 5 was positive 41 times (6%) and negative 7 times (4%) with returns ranging from a positive 53% to a negative 8%. There is a similarly low (next-to-zero) predictive power when the yield curve is positively sloped (right-hand chart). The key conclusion here is that inverted yield curves have always led to stock price declines eventually, but simply being told the -1 spread at any given point gives you little insight into prospective stock market returns. We also looked into whether the change in the - 1 spread (i.e. measuring the steepening or flattening of the yield curve) gave insight into future stock market returns and found similarly low predictive power. EXHIBIT : YIELD CURVE NOT A GOOD PREDICTOR OF STOCK MARKET RETURNS STOCK MARKET/YIELD CURVE RELATIONSHIP INVERTED CURVE POSITIVE CURVE R² =. R² = Yield curve steepness Yield curve steepness Source: Northern Trust Investment Strategy, Bloomberg. Data from 1/3/1977 to 9/3/16. Inverted yield curves have always preceded recession over the last 4 years. However, similar to the relationship to stock market declines, it can be some time before the recession actually occurs (as seen in Exhibit 3). During the mid-s, the yield curve inverted at the end of 5; it took a full two years for the U.S. economy to go into recession. An inverted yield curve led the early 198s recession by 17 months, the late 198s/early 199s recession by 18 months and the early s recession by 13 months. The amount of lag between inversion and recession introduces skepticism that the yield curve is predicting recession. Rather, it provides some evidence that recession is a natural outcome of the challenges presented by a flat-to-inverted yield curve. As such, central bankers should feel a certain responsibility to maintain a healthy positive slope to the yield curve if possible and we think they do. That is to say, absent inflationary pressures, we think the Fed will be careful to not significantly flatten the yield curve unnecessarily and risk a self-induced recession. EXHIBIT 3: A RECESSION AFTER EACH INVERSION WITH A LAG YIELD CURVE SPREAD AND ECONOMIC RECESSIONS Recession 1-year UST yield minus -year UST Average spread Source: Northern Trust Investment Strategy, Bloomberg, NBER. Monthly data: 1/31/1977 through 11/3/17. -3

3 Percent (y/y, %) Rate (%) INVESTMENT STRATEGY COMMENTARY Exhibit 4 illustrates the impact of the Fed on the shape of the yield curve. All four major periods of yield curve inversion were preceded by Fed rate hike campaigns. And in all four examples, inflationary pressures, either occurring or expected, played a significant role in the Fed s policy moves. EXHIBIT 4: FED HIKES CAUSE INVERSIONS, INFLATION CAUSES FED RATE HIKES 1 INFLATION VS. FED FUNDS RATE Dec-77 Dec-83 Dec-89 Dec-95 Dec-1 Dec-7 Dec-13 Inverted yield curve Inflation (core PCE LHS) Fed Funds rate (RHS) Source: Northern Trust Investment Strategy, Bloomberg, Monthly data: 1/31/1977 through 1/31/17. Ahead of the first inversion period, beginning in the late-197s, the Fed funds rate was increased from 6% to 8.5% with the Fed funds rate peaking at % in May This aggressive policy, led by Fed Chief Paul Volcker, was specifically aimed at taming nearly double-digit inflation. The policy eventually pushed the economy into a double-dip recession in the early 198s. The Fed funds rate moved from 5.88% to 8.75% before the second inversion period that started in the late-198s. The Fed funds rate peaked at 9.75% in February Inflation, as measured by core Personal Consumption Expenditures (PCE), began climbing quickly in the late 198s from.8% to eventually reach 4.7% and was a significant catalyst for the rate hike cycle. The Fed funds rate increased from 4.75% to 5.75% preceding the third inversion period of the early-s, eventually peaking at 6.5% in May. The Fed was reacting to what it believed to be a potential outbreak in inflation while also dealing with material asset price inflation (at the time the Fed began raising rates, the S&P 5 had a price-to-earnings ratio of 3).Core PCE moved from 1.% just prior to the Fed rate hike campaign, but remained mostly below %. The final inversion period in the mid-s followed a Fed rate hike cycle pushing the Fed funds rate from 1% to 4.5% with the Fed funds rate finally reaching 5.5%. The Fed s tightening was a reaction to an overheating housing market, one of the inflation index s largest components. Core PCE moved from a cyclical low of 1.3% to a cyclical high of.4%. Notably, there was one significant Fed rate cycle that did not result in an inverted yield curve. The Fed saw long-term interest rates climb in the period leading up to the tightening cycle of the mid-199s and feared inflation would follow. In this case, the Fed proactively started raising rates without upward inflationary pressures in the data. If the long-end of the yield curve follows the short-end upward, the risk of inversion is avoided. In our current environment of global quantitative easing, however, interest rates are at extremely low levels and we believe this will create a ceiling on rising rates. The left panel of Exhibit 5 shows the percent of global bonds with negative yields currently sitting at about 18%. We calculate this using the market value of the Bloomberg Barclays Global Aggregate Negative Yielding Debt Index ($8.9 trillion) over the market value of the Bloomberg Barclays Global Aggregate Index ($49.1 trillion). Japan, Germany and France are the main drivers of negative yielding bonds, collectively making up ~7% of the Negative Yielding Debt Index, with 9 other countries making up the remaining market value. The impacts of zero/negative interest rate policy and quantitative easing are the cause of this phenomenon. 3

4 Percent of negative yielding bonds (%) Yield spread (%) INVESTMENT STRATEGY COMMENTARY The right panel chart of Exhibit 5 compares the 1-year U.S. Treasury (UST) yield to its respective 1- year German and Japan counterparts. Since the data began, the 1-year UST has had a more attractive yield than the Japan government bonds. The 1-year UST also has had a higher yield than the German bund since the financial crisis. With the increasing proportion of global bonds with negative yields, yield-searching foreign investors are likely to keep the 1-year UST from moving too high. Interestingly, non-u.s. buyers have even been buying U.S. municipal bonds for which they get no tax benefits due to the higher available interest rates. EXHIBIT 5: IN THE LAND OF NEGATIVE RATES, THE 1-YEAR UST IS KING GLOBAL NEGATIVE YIELDING BONDS 3 1-YEAR U.S. TREASURY YIELD LESS Dec-9 Dec-11 Dec-13 Dec Jan-89 Jan-94 Jan-99 Jan-4 Jan-9 Jan-14 1-year Japan JGB yield 1-year German bund yield Source: Northern Trust Investment Strategy, Bloomberg, Barclays. Index used on the left chart is the Bloomberg Barclays Global Aggregate Index. Note: JGB = Japanese Government Bond. Data through 1/31/17. We don t think these conditions are likely to change anytime soon. The Bank of Japan (BOJ) has no plan of stopping its quantitative easing program with BOJ Governor Haruhiko Kuroda determined to hit the Bank of Japan s % inflation target (currently at %). The Bank of Japan s policy rate is expected to remain at -.1% and its quantitative easing program continues to purchase 6 trillion of assets per year (including Japanese government debt, corporate bonds, ETFs and REITs). European Central Bank (ECB) President Mario Draghi, dealing with subpar inflation levels as well, has noted that the ECB will not increase policy rates until its bond buying program is complete. The ECB will decrease its bond purchase program from 6 billion per month to 3 billion per month in January 18 but has extended this program through at least September 18. CONCLUSION We understand recent investor nervousness over the flattening yield curve. The last two U.S. equity bear markets were both preceded by flat-to-inverted yield curves. And a historical analysis of the past 4 years of data shows inverted yield curves have always led to stock market declines. However, these stock market declines take time to materialize, suggesting that an inverted yield curve is less a predictor of stock market declines than a challenge to economic functioning (ultimately leading to stock market declines). We are sure the Fed is cognizant of this history and, absent an upsurge in inflation that forces its hand, will seek to avoid significant yield curve flattening. That said, we will be keeping close watch on the slope of the yield curve given the challenges it can create. Currently, that slope (as measured by the -1 spread) is.6%, only modestly below the long-term average of 1.%. Our expectation over the next year is that the Fed will likely raise rates twice and the 1-year Treasury will trade between.5% and.75%. While these conditions would likely keep the yield curve flatter than historical averages, we don t see them leading to a sustained yield curve inversion. With inflation low and fundamentals strong, we remain constructive on the risk asset outlook. Special thanks to Tom O Shea, senior investment analyst, and Daniel Ballantine, senior investment analyst, for data research. 4

5 INVESTMENT STRATEGY COMMENTARY APPENDIX YIELD CURVE INVERSION CYCLES Early 8s Late 8s Early s Mid s CURRENT* Initial inversion date Aug-78 Jan-89 Feb- Dec-5 N/A Months until stock market decline N/A Months until recession N/A Length of recession (months) 33** N/A Peak inversion date Feb-8 Mar-89 Mar- Nov-6 N/A Peak inversion (%) N/A At the time of initial inversion Fed funds target rate (%) year U.S. Treasury yield (%) year U.S. Treasury yield (%) Credit spreads (%) N/A N/A Unemployment rate (%) Capacity utilization (% of total) S&P 5 P/E ratio Manufacturing PMI (level) During the 1 months before initial inversion Fed funds target rate (% change) year U.S. Treasury yield (% change) year U.S. Treasury yield (% change) year - -year Treasury yield (% change) Credit spreads (% change) N/A N/A Unemployment rate (% change) Inflation (Core PCE, % change) Real economic growth (Real GDP, %) Wages (% change) Capacity utilization (difference) S&P 5 P/E ratio (% change) S&P 5 earnings (% change) S&P 5 price return (%) Manufacturing PMI (difference) During the 1 months after initial inversion Fed funds target rate (% change) year U.S. Treasury yield (% change) year U.S. Treasury yield (% change) year - -year Treasury yield (% change) Credit spreads (% change) N/A N/A Unemployment rate (% change) Inflation (Core PCE, % change) Real economic growth (Real GDP, %) Wages (% change) Capacity utilization (difference) S&P 5 P/E ratio (% change) S&P 5 earnings (% change) S&P 5 price return (%) Manufacturing PMI (difference) *Current data as of 1/31/17, **Double-dip recession includes recessions beginning in January 198 and July

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