Published on March 21, 2019
Conventional wisdom dictates that recessions occur every time the yield curve inverts, but in our view that is an oversimplification.
Over the past few months there has been a lot of angst about the looming dangers of an inverted yield curve. Given that every recession since 1957 has been preceded by an inverted curve, we appreciate the concerns. Nonetheless, we do not believe the current inversion is a genuine cause for alarm. There have been multiple instances where the curve has inverted without a recession, and we believe we are currently experiencing such an occasion.
As you can see from the chart below, the spread between 2-year and 5-year Treasury yields has been negative nearly every trading day since early December. The inversion began when the equity market started its fourth quarter selloff, but it did not revert in January even though stocks began to recover their losses. In fact, the 2/5 spread is more negative today than it was in the depths of December’s correction.
Interestingly, the spread between the 2-year and 10-year Treasury yields also dropped precipitously during December, but it never dipped below zero and it widened when the market rallied. This reinforces our view that a recession is not imminent, as historically the 2/10 inversion has been the most reliable precursor of a downturn.
Still, the stubborn nature of the current 2/5 inversion continues to cause concerns about a slowdown, but in our view there are other factors to consider to assess the significance of an inverted curve. Specifically, we think the absolute level of interest rates and the general state of the economy are crucial, and we believe both of those factors indicate that a recession is not imminent.
Despite the modestly inverted curve, interest rates remain near historic lows. The Federal Reserve has increased short-term rates four times since the beginning of 2018, but the longer end of the curve has risen at a more measured pace. The current 10-year U.S. Treasury yield is at 2.64%, which is well below historic norms. Moreover, as you can see from the chart below, during the past 50+ years 10-year yields have not been this low heading into a recessionary period (note the vertical shaded bars). In our view, so long as rates remain somewhere near their current levels, we feel that both corporations and individual borrowers should be able to service their current obligations and maintain the flexibility to refinance and/or take on additional leverage.
On a related point, we do not see any major red flags in the current economic data. While inverted curves are a bearish indicator, they are generally a symptom rather than a cause. For a slowdown to take root, there needs to be an underlying imbalance in the economy. In 2008, the Great Recession was caused by a complex cocktail of creative lending practices (primarily to subprime borrowers), “advancements” in securitization, and a systematic failure by the rating agencies to properly quantify the risk of these new instruments. The results were tragic and far-reaching, creating catastrophic effects across the economy. The previous recession, in 2001, was triggered by the so-called Dot-Com Bust, when the stock market bubble burst for high-flying, first-generation internet companies.
We currently do not see a comparable catalyst on the horizon. In late 2018, as the equity markets were swooning and the yield curve was just beginning to invert, there was a lot of talk about systemic risks within the BBB corporate markets. Commentators and the financial press seemed to agree that that the BBB market had grown too rapidly, signifying a general deterioration of credit quality that could lead to mass downgrades or worse. In our view, those concerns were overblown.
Inflation is another material risk to the economy, and we track it very closely, but the recent data suggests that it is largely under control. Last week’s Consumer Price Index (CPI) checked in at just 0.2%, and the latest Underlying Inflation Gauge (UIG), which is a forward-looking measure, decreased from 3.06% in December to 2.99% in January. Despite the drop, UIG data continues to suggest that inflationary pressures may be increasing, so that is an area to watch.
Overall, we feel the economy is in good shape, and we do not believe the current yield curve inversion is a harbinger of a recession.
Vice President & Senior Portfolio Manager
Eddy VataruView Bio
Vice President & Senior Portfolio Manager
Eddy Vataru graduated from California Institute of Technology (B.S. Chemistry & Economics) and from Olin Business School at Washington University in St. Louis (M.B.A.). Mr. Vataru holds the Chartered Financial Analyst designation.
Prior to joining Osterweis Capital Management in 2016, Mr. Vataru worked in senior management positions at Incapture, LLC and Citadel, LLC. Before that he spent over 11 years at BlackRock (formerly Barclays Global Investors), where his last position was as Managing Director and Head of U.S. Rates and Mortgages. While in this role, BGI worked with the U.S. Treasury in implementing its Agency MBS Purchase Program, buying mortgages for the U.S. government from 2008-2009.
Mr. Vataru is a principal of the firm and the lead Portfolio Manager for the total return fixed income strategy. He is also a Portfolio Manager for the flexible balanced strategy.
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A basis point is a unit that is equal to 1/100th of 1%.
Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.
The Underlying Inflation Gauge (UIG) captures sustained movements in inflation from information contained in a broad set of price, real activity, and financial data.
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