The yields on U.S. bonds fell largely in sympathy to the sharp drop in yields overseas, mostly in Europe. German bonds up to 10 years maturity fell into negative yields. That had the effect of driving yields worldwide lower.
The inversion of the U.S. yield curve between 0-5 years started a fear frenzy as soon as last week’s FOMC meeting ended. Although the 2-10 year yield spread remains positive at about 14 basis points, in line with its relative position for the last several months, the fact that 0-5 year yields are now sequentially lower has sent shock waves throughout markets. Thursday saw a big rally after the FOMC meeting only to reverse to a 1-2% loss on Friday as the short end of the curve inverted. Monday was a transitional day with little net change, and yesterday saw a solid morning rally dissipate as the session wore on.
What does this all mean?
- Confusion – When yield curves invert, the odds increase substantially that a recession might occur within the next two years. Did we get that message on Friday? The 3-month 10-year curve did invert and that was the biggest trigger. But the 2-10 year curve didn’t budge nor did yields on inflation protected Treasuries (TIPS). Spreads between low and high yield bonds, which would normally expand in front of a recession, barely budged. In short, one can only extrapolate from last week a mixed message. The net result is that inflation concerns have risen and should rise, but so far there is really no concrete evidence that the U.S. economy is on the brink of recession.
- Economic Deceleration – There have been many signs the economy is decelerating. They have been evident for months. Whenever one sees deceleration, it is hard to see it coming to an end. It is easy to presume the worst, that deceleration will end in a recession. But a degree of logic suggests that a recession isn’t just around the corner. Jobs continue to increase, while weekly unemployment claims remain near record lows. Real wages are rising and the consumer is flush with cash. Demographics point to an emerging millennial class willing to spend.
- The Rest of the World? – There is little doubt the rest of the world is slowing. Europe is near recession, China has been slowing for months, and Japan is trying to stay out of recession with aggressive monetary policy. But trade makes up just a tiny portion of our economy. That is not to say that we are immune from recession overseas, but we probably are immune to a modest slowdown. Remember during the European debt crisis earlier this decade, Europe had a nasty recession and we barely budged.
- Tariffs – Of course they matter. It would be great if China and the U.S. resolved their differences. But that isn’t the root cause of today’s yield curve. With that said, both China and the U.S. want to resolve the crisis. China is facing a real slowdown in growth and we are less than 18 months from a Presidential election. Recessions don’t help incumbent Presidents. Ask George H.W. Bush and Jimmy Carter. If Mr. Trump is going to lose in 2020 it will be much easier for the Democrats if our economy is in recession. No tariffs are a good start to a reelection campaign.
It is true that it is very hard to see a recession until it is almost upon us. But recessions are born from seeds created by imbalances. Today, banks are in great shape and lending seems contained. Savings rates are higher than in recent past. Speculative excesses are hard to find. Perhaps an IPO boom led by names like Lyft and Uber will change that but one can speculate on future excesses that may never occur. The real estate market is stable and stocks sell close to historic norms in terms of P/E ratios.
Thus, while acknowledging that one needs to pay attention to the message of the yield curve, there is almost no economic data to suggest an imminent downturn. The lead time between inversion and a recession can be as long as two years or as short as a few months. Stocks can still rise a long way between the first inversion and the end of a bull market. For now, we remain optimistic while paying respect to last week’s inversion. Should it last for several weeks or months, we will pay more heed. With that said, some good economic numbers over the next few months could steepen the yield curve quickly and eliminate short term fears.
Today, Fergie is 44. Mariah Carey is 49.
James M. Meyer, CFA 610-260-2220