Caution Warranted When Tying Yield Curve Inversions to Recession

One expert suggests the current yield curve inversion—often called a harbinger of recession—is due more to declining inflation expectations and the weight of negative bond yields in Europe.

Speaking with PLANADVISER during what has proven to be something of a wild week for the U.S. and global equity markets, investment experts reiterated their perspectives that a recession is not very likely in the near term.

The recession risk is higher now with the trade issues, they note, and the fact that corporate profits are slowing down, but a recession is generally not in most economists’ base case. When it comes to interest rates in the U.S. and what influence the Federal Reserve’s recent rate cut may have had on equity markets here and abroad, most say the 25 basis point cut was to be expected.

Still the market reaction to the rate cut was still significant. Some speculate that President Trump tweeting about his feelings that a bigger rate cut is needed caused some of the market jitters. The markets have also seemingly reacted to the chief executive’s heated tweets the yield curve.

Reading the Yield Curve Tea Leaves

Christopher Hyzy, chief investment officer at Merrill, a Bank of America company, suggests the current yield curve inversion—often called a harbinger of recession—is due more to declining inflation expectations and growth expectations, and the weight of negative bond yields in Europe.

“If the Fed begins an easing campaign, the short end should begin to turn downward, changing the shape of the overall curve,” he says. Longer-term bonds typically offer higher returns, or yields, to investors than shorter-term bonds. The yield curve inverts when yields on that shorter-term debt exceeds those on longer maturity debt.

Hyzy adds that some market watchers believe the U.S. is the late stages of the business cycle with a rising probability of a recession. However, he says, Merrill believes there have actually been a series of “mini wave” pullbacks that have made a significant recession less likely. 

“We are in the early to mid-stages of the fourth mini wave since the Great Recession,” Hyzy suggests. “Our view is largely based on current economic conditions, many of which are not typical of a cycle’s late stages historically.”

Volatility Likely to Tick Higher

Offering some additional context for the recent market volatility, the Natixis Midyear Strategist Survey suggests outcomes for 2019 will be “more muted as markets grapple with a number of downside scenarios and little in the way of upside surprises.”

According to the survey, a “messy Brexit outcome” is the most likely downside risk, while a rebound in growth driven by new central bank policy ranks as the most likely upside. The survey also identifies a more bullish outlook for U.S. sovereign bonds, emerging market equities, global real estate investment trusts (REITs) and emerging market bonds due to accommodative central bank policy.

“The survey results clearly show that, in aggregate, our respondents don’t see a lot of positive market catalysts on the horizon—nor do they see a recessionary worst-case scenario as very likely in the near term,” says Esty Dwek, head of global market strategy, dynamic solutions, Natixis Investment Managers. “It’s a kind of a ‘muddle through’ outlook.”

Natixis strategists predict little in the way of equity returns in the U.S. and Eurozone over the next six to twelve months. But that’s not to say the consensus calls for dramatic losses either. Overall, according to the survey, the outlook on equities is balanced and no strategists forecast a bear market (-20%) or even a market correction (-10%) in this time frame. On average, the strategists predict the U.S. Fed will ease rates back by 50 basis points by year-end. In Europe, respondents see further easing from the European Central Bank (ECB) and anticipate a 5 bps to 10 bps reduction in the overnight deposit rate.

The Natixis strategist projections for volatility go hand-in-hand with the equity outlook, anticipating a slight increase in volatility, “with the VIX rising 2.1 points from its mid-year level of 15.1.” This average projection to 17.2 represents “a modest but meaningful increase in volatility overall.” The VIX is the Cboe Options Exchange Volatility Index.

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