Today’s monetary policy is entirely different from the way OECD countries have conducted this policy since WW2. Central banks have since 2008 manipulated the shape of the yield curve by purchasing government bonds (among other things) with maturities longer than two years. Since the Great Recession, central banks have also lowered their targets for the long-term real interest rates to around zero. This means that they have kept policy easy despite regular strong economic showing in recent years.
In this light, investors should be cautious with the shape of the yield curve as a predictor.
Yesterday’s sell-off is nevertheless driven by fear of what the US bond market is now predicting. The yield curve between 2 and 10 years has since FED’s rate cut July 30 flattened 30 bps closing at a precisely flat curve or zero spread at yesterday’s close. Wall Street reacted with fear and sold off around three percent in the benchmark indices.
There are two predictions that investors have to notice:
A) a severe slow-down of the US economy in 2020
B) the S&P500 index bull market end.
A. With a lead of around 18 months, the yield curve is now prediction negative real GDP growth in the US by 2020. Since 1990, this prophecy failed in both 1996 and 2000 (see chart below)
- An S&P500 index peak and an end to a multi-year equity Bull trend was rightly predicted in 1990, 2000 and 2007. (see chart below)
Our short conclusion is:
1) Fed’s last rate cut may have unintentionally triggered Recession fear in financial markets. What is it FED sees that we do not?
2) We doubt that the ability to predict is as good as the curve has been in the last 30 years. Monetary policy is completely changed meaning that the curve should have been steeper if not manipulated flatter by FED and others.
3) The level of short-term interest rates means a lot for the performance of longer-dated bonds. Carry-roll positions have been attractive drivers of curve flatteners both in the US and in Europe.
4) Investors have flooded Risk-off instruments since last summer. They continued to do so despite global equities recovered here in 2019. FED just gave investors a new argument for rotating further out of High-Risk assets to Low-Risk&/Risk-off assets when cutting Fed Funds target rate in July.
5) A serious of indicators have for months suggested that global growth is slowing, and that the US is in from summer 2019 following the same path. One can easily argue that the equity market has ignored these signals with the market rally here in 2019. In other words, you do not need to look at the US curve shape to forecast slower growth. The 2-10 year curve is, however, starting to predict a Hard landing for the US economy, in 2020, which no data leads yet have begun to indicate.
6) Our approach is still to keep Neutral weighting between equities and bonds. We need more than a manipulated yield curve to forecast US recession.