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Is the bond market predicting a recession?

By The English Investor 2 Comments

As some of you know, I’m a high-yield bond lawyer. What this means is that I take care of the legal documentation in the context of offerings of sub-investment grade debt (i.e. “junk bonds”).

This does not mean I’m an expert at timing bond investments. However, I’m definitely closer to this particular market and I can see broad trends: is the market busy? Are companies issuing bonds for opportunistic refinancings or acquire other companies? Or are corporates turning to loans because the pricing offered by banks is more attractive?

When the Fed appeared to raise rates on “auto-pilot”, markets panicked. Equities tanked and new bond offerings vanished. Market conditions were too volatile. More importantly, why would you invest in a risky “high-yield” bond at 4% when you could get 3% guaranteed from the U.S. government?

Bond investors were asking for a higher coupons, and companies were essentially waiting out to see if this was a temporary pushback for investors or the new normal.

For a while, it seemed that normalization was firmly underway after an era of quantitative easing and cheap money. Call it a reversion to the mean.

And then the U.S. yield curve inverted and everybody panicked.

The yield curve in a “normal” environment

The yield curve is a dotted line on a graph that indicates the yield of fixed-income securities against the length of time left until maturity. When the economy functions properly, the yield curve trends upward. Why?

Due to inflation, the value of a dollar or a pound is less tomorrow than it is today. Therefore, investors will ask for a higher yield to at least offset the inflation that will dent their returns over time.

There are also other factors at play. Holding a security for a longer period means that you cannot reinvest your money in the meantime. That’s an cost. Additionally, there are increased risks and uncertainty in holding a security for a longer period of time (i.e. predicting events in three months tends to be slightly easier than predicting the next 30 years).

If you want to learn more about the basics, Sam at Financial Samurai wrote a nice post a couple of months ago. I encourage you to read it here.

The inversion of the yield curve: why it matters

As explained by Investopedia, “an inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality.”

To the avid reader, this should make no sense. Why would investors agree to lend money with a longer term maturity and for a lower coupon? Why not just take the money for the three-month bond?

Answer: if you expect things to get worse and taking the lower coupon is still the best way to protect your money for the foreseeable future. In other words, an inverted yield curve is considered to be an indicator for a future economic recession.

One could reasonably argue that an inverted yield curve is simply an indicator. Economic theory is one thing but reality is a very different one.

The issue is that an inverted yield curve proves to be a very accurate indicator in light of the past decades.

How accurate you wanted to ask? Historically, inversions of the U.S. yield curve have preceded many – if not all – US recessions. For instance, the last inversion occurred right before the 2007/2008 subprime crisis. With maybe one false-positive in the last 60 years and no recessions ever having a false negative, investors value an inverted yield curve as a prime indicator for investors across the globe.

The self-fulfilling prophecy argument

There might be an element of self-fulfilling prophecy here, which cannot be ruled out. If someone argues that the yield-curve is not a reliable indicator because it is the result of a self-fulfilling prophecy, that person might be right. More importantly, however, the outcome remains the same. If corporates and individuals believe a recession is coming, investments and spending will be curtailed, and growth will nose-dive.

To quote a friend, “a self-fulfilling prophecy is still a valid prophecy and there is no point in fighting market psychology since none of us can stop the stampede.“

Which yield curve recently inverted?

Following reports showing weaknesses in France and Germany, along with a slowdown in a key U.S. manufacturing index, the gap between the 3-month and 10-year rates turned negative. In the context of U.S. Treasuries, this means that the yield for lending money for debt with a ten-year maturity is now lower than the one available for a three money maturity.

According to Bloomberg, this portion of the curve flipped to inverted in early 2006. This was right in the lead-up to the economic downturn that started in 2007.

I also believe that the dovish announcement from the Fed that it would continue with its “wait and see” approach amid a slew of mixed economic data contributed to the inversion. As a result, market participants cut their expectations in seeing another interest rate increase before the end of the year. This is consistent with money-market traders betting that the Fed might even cut rates by the end of the year if the underlying data fail to improve significantly. This impacted the upward trajectory of the curve.

The San Francisco Fed called the 3-month-to-10-year spread the most useful for purposes of forecasting recessions. However, it is not the only key spread to look for.

There are multiple “yield curves” waiting for their inversion. Theoretically, you could look at the 5-years-to-10-year spread. But, to be a useful indicator, it is more appropriate to compare reasonably short term maturity to longer-term maturity.

The 2-year-to-10-year spread is also considered to be a very valuable indicator. Investors already responded strongly to the first inversion in over a decade with the Nasdaq down 2.5% on Friday and the Footsie 100 down 2.01%. An inversion between the 2-year and 10-year rates is likely to cause further market jitters.

And we are getting very close now. The spread only stands at 0.13%.

Source: charts.com

But this is a new world…

Some have argued that the yield curve’s importance is overstated in light of the flow of liquidity. The argument is the following: quantitative easing has distorted our markets and the liquidity environment. This is true from low-interest rate mortgages to negative interests in Europe. Economies are flushed with liquidity and therefore, the normal signal sent by an inversion of the yield curve is distorted and could simply be a false positive.

Only time will tell if this is true. However, there are two observations to be made. First, rates are lower, that’s true. Maybe it’s only a matter of moving the range where the yield curve sits. Instead of comparing 4% in the short term and 7% in the long term, we now have 3% and 5%. The point of origin may change but the trend remains: an inversion should not occur. Second, again, this does not alter the outcome of a self-fulfilling prophecy.

It usually takes 36 months to assess if an inversion is a false positive. Inevitably, there is a lag in the receiving the data, especially with the fairly recent U.S. shutdown. If no recession occurs in the next three years, then the skeptics may be right.

Is it time to readjust your portfolio?

It’s already difficult to assess whether a change in allocation is due in your portfolio when the stock market is crashing.

Readjusting your portfolio allocation BEFORE the imminent stock market crash tends to yield better results.

If you believe that the inversion of the yield curve is a reliable indicator in predicting a recession or a selloff in the stock market, then it’s time to take corrective actions.

In a recession, stocks and bonds move in opposite directions. If you believe that stocks are overvalued and that the equity market has not yet fully internalized a recession, then buying (i) government bonds, (ii) high-value corporate bonds (so not high-yield bonds, think of Apple instead) or (iii) mortgage-backed securities (the quality of the mortgage pool has improved since 2007) are reasonable options.

As always, you should do your own research. And yes, investing always carries a degree of risk. Personally, I am having a hard time getting comfortable with the fundamentals here, whether in the United States or in Europe especially. Any trade deal between China and the U.S. will only result in a temporary boost. There is no further room for tax cuts. House prices in key cities such as London and New-York are slowing. And manufacturing data continue to disappoint. As of today, it is difficult to see the next catalyst that would boost corporate earnings.

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Filed Under: Investments Tagged With: bonds

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Comments

  1. Juana Gonzalez says

    at

    Hello there,
    I would love to get in touch with you. Do you have an email contact where I can send you a proposal for a collaboration on writing an article about us (an amazing investment platform) in your blog, and earning money with our affiliate program?
    Have a nice day!

    Reply
    • The English Investor says

      at

      Hi Juana,

      Thanks for reaching out. Feel free to send me an email: theenglishinvestor@theenglishinvestor.com

      Thanks

      Reply

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