The Yield Curve: Predicting a Recession?

On March 27, 2019 the US Yield Curve inversed. More precisely the spread between the 10- years and the 3-months Treasuries. This event generated many alarming headlines and is significant. The yield curve is one of the most closely followed economic indicators and for good reason. It has historically been one of the best predictors of upcoming recessions.

The concept of the Yield Curve

Prior to analysing the issue, let’s consider the meaning of the yield curve. Simplifying slightly, the yield curve notion is simple: it is the difference between the short term and the long term interest rates. Usually, long-term interest rates are higher than short term rates. 

The reason for the premium investors require to invest into longer dated bond is primarily due to the uncertainty regarding future levels of inflation. While there is usually good visibility on short term inflation, there is considerable uncertainty regarding the level of long term inflation and therefore it makes sense for investors to require a higher rate.

However, there are instances, relatively rare, where the long term interest rate is lower than the short term interest rate – in such a case, the yield curve has inversed. The likeliest explanation for such a situation is that investors are quite gloomy about the economic outlook, and assume that the weak economy will force the central bank to lower interest rates considerably going forward. 

What will happen?

While there are many economic indicators that reflect market expectations regarding future economic developments none of them comes close to the inversed yield curve in terms of their effectiveness as a leading economic indicator. In the last forty years the yield curve inverted five times and was followed by a recession every time1. Since 1960, the yield curve inversions predicted eight out of the nice recessions 2. Typically the time lag between the inversion and the recession was 18 months3. Every recession brought with it a significant market correction. 

With such a powerful indicator negative, does it mean that a recession and a major market correction are imminent? “This time is different” is an often heard expression in financial markets but financial history tends to repeat itself. Nevertheless we believe that there are a number of important points to consider and that this time might really be different.

Firstly, usually at the turning point before a recession real rates are high and credit quality starts worsening with widening credit spreads. At present current real rates are near zero versus 3% prior to the past 6 recessions.4This is a significant difference.

Secondly, the spread between the US 10-years Treasury and the German government Bund is 250 bps which is close to the top of the range for the last 30 years. In other words, the low interest rates in the US is also influenced by the very low rates in Germany and other major economies outside the US.4

Thirdly, so far it is only the 3 months to the 10 years spread that turned negative while the 2 years to the 10 years spread has so far not inversed and has historically been a more significant leading indicator.3 

Fourthly, the credit curve on corporate bonds is far from having inversed: “The difference in the credit spread between short- and long-dated U.S. corporate bonds is around 120 basis points, well above its average of 80 basis points since 2000. That spread difference last inverted in March 2008, about five months before the financial crisis”.5

Fifthly, when considering the current situation one has also to remember that over the last decade interest rates have been impacted by policy decisions of the central banks in an extreme way that has no historic precedent. This creates distortions which are making past history less relevant in understanding the current situation.

In summary there are good reasons to believe that this time might be different. However, one should not dismiss the inversion of the 3-months to the 10 years Treasuries outright. The fact that it was driven by a drop in the real long term interest rates is worrying in and for itself as it implies weak macro expectations on the side of credit investors. The current yield curve structure also makes it harder for banks to make money by hurting their lending profit margins.2

With high employment, overall solid US macro data and the improvement in China, it seems in our view overall likely that a recession is not imminent despite the inversion.

Implications

An inversion of the spread between the 2-years and 10-years Treasuries or an inversion of the corporate credit curve could be more powerful signals of an upcoming recessions and should therefore be closely monitored. In such a case, risk should be minimized very fast.

Conservative investors should in our view continue to be defensive and rather err on the side of caution. 

Beyond any practical implications, we hope that this paper makes clear to which extent markets are complex. Nobody can predict them reliably, the best one can do is to manage risks in order to achieve an optimized long-term performance with a controlled risk level. 

Orit Raviv Swery                                                    Ilan Weil

Founder & CEO                                                     Chief Investment Officer

 

1.      https://www.schroders.com/en/insights/economics/the-yield-curve-explained-is-it-predicting-recession/

2.      https://www.zerohedge.com/news/2019-04-01/stock-market-confused-you-are-about-recession?

3.      https://www.bloomberg.com/news/articles/2019-04-08/jpmorgan-says-stock-traders-are-looking-at-the-wrong-yield-curve

4.      https://www.forexlive.com/news/!/three-reasons-why-this-yield-curve-inversion-is-different-20190408

5.      https://www.bloomberg.com/opinion/articles/2019-04-08/yield-curve-inversions-and-recessions

6.      https://fattailedandhappy.com/2019-yield-curve-inversion/

7.      https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/TextView.aspx?data=yieldYear&year=2019

8.      https://www.reuters.com/article/us-usa-economy-yieldcurve-analysis/one-part-of-the-us-yield-curve-just-inverted-what-does-that-mean-idUSKBN1O50G1

9.      https://www.gurufocus.com/yield_curve.php

10.    https://www.marketwatch.com/articles/the-stock-market-is-just-as-confused-about-a-potential-recession-as-you-are-51553590800?mod=mw_theo_homepage

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Seeking to generate value in a challenging market

2018 was an exceptionally challenging year for international investors. In some respects it has proven even more challenging than the big financial crisis of 2008. During the financial crisis some asset classes still managed to generate appreciable returns, particularly US Treasuries which benefitted from the “flight to safety”. In 2018 the prices of both equities and bonds dropped as well as most other asset classes. In fact, according to Deutsche Bank since 1901 there has not been any other instance where so many asset classes went down as illustrated in the following graph (1). 

graph small.png

The S&P 500 was down 6% and other indexes did much worse with the Euro Stoxx 50 down 14% and the German DAX down 18%. The iBoxx Investment Grade bond index was down 4%. Commodities are often inversely correlated to the markets and gold is often a beneficiary in times of uncertainty. This year it was not the case. Those two asset classes traded down 14% and 2% respectively. Overall hedge fund managers did poorly, with the global HFRX fund index which includes all types of strategies down 7%. The HFRX Equity Hedge index which focuses on long-short managers was down 9%. 

Fortunately we have been very cautious about the markets for some time and had warned repeatedly about the risky mix of increasing interest rates and elevated valuations. All this being further exacerbated by macro risks such as a cooling of the Chinese economy and international political tensions. We therefore had limited exposure to equity markets as well as to long-duration fixed income. Overall our hedge funds performed better than the industry average, validating our careful selection of managers who have a real ability to manage risks and add value. At the bottom line, we managed to preserve capital and to largely insulate our portfolios from nerve-wrecking volatility.

We continue to believe that the same risks that were present at the beginning of 2018 remain now even after the correction. We continue to advocate caution although some opportunities are starting to emerge. Healthcare and biotech stocks in particular are trading at historically low valuation levels and offer a good entry point for the long term investor.

One of the most promising avenues to generate returns uncorrelated to the markets are investments into promising private companies with high growth potential. To the difference of the financial markets whose evolution depends largely on external factors the outcome of good private equity investments is a lot more under the control of the investors. 

One such opportunities is Paltop dental into which we invested some of our clients’ money over the last four years. The company, which is growing strongly and is already profitable, just merged with the American dental implant distributor Keystone to form a new dental implants player with the potential to become one of the industry leaders. The merger was reported in the Israeli press (2).

As the case of Paltop shows opportunities also exist in more traditional industries through technologic and managerial innovation. In terms of timing we prefer to avoid the highest-risk early stages and to enter at later stages where the feasibility of the venture is more established but the gain potential still high. Israel as the Startup Nation offers plenty of opportunities since many high quality professionals are eager to start successful, innovative businesses. The main limitation of such private investments is the above-average risk, the lack of liquidity and the relatively high minimal investment amounts. This prevents many investors from participating in them. Going forward, we want to take more and more advantage of such opportunities and we will think of possible ways to make them more accessible to investors who are not traditionally exposed to such investments.

While preparing for all types of scenarios we hope that 2019 will surprise us on the upside.

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1 - https://www.zerohedge.com/news/2018-11-01/record-number-assets-are-down-year

2 - https://m.calcalist.co.il/Article.aspx?guid=3753604