Market Insights: The bond-yield curve dilemma

The bond-yield curve dilemma

A bond-yield curve (BYC) inversion has correctly predicted the last seven U.S. recessions.  A BYC inversion occurs when the U.S. 10-year bond rate is lower than the 3-month rate.  In fact, this was the primary reasoning behind our own move to a defensive stance in our portfolios back in early 2007, as we'd noted that the BYC had inverted from August 2006 until May 2007.  The move on our part was early, since the equity markets continued higher, until peaking in October 2007 (a seemingly long time back then), and most people didn't really feel the brunt of the Great Recession drawdown until the last quarter of 2008 and first quarter of 2009.  However, this decision proved to be the correct one in the end.  

This dilemma with regards to a flattening yield curve in the U.S. has been receiving more and more attention of late.  Some have argued that this signal is no longer valid with short-term rates held down close to zero or even below zero by central banks around the world (Zero Interest Rate Policy, also known as ZIRP).  However, if we look at the spread between the 10-year and the 2-year rate in the U.S., it is now at its lowest level of this cycle.  For many, this is a signal of very slow growth, and if it continues to flatten it could potentially forecast an oncoming recession.  With ZIRP in play around the world (the U.S. has recently moved up off this floor), perhaps this 10 and 2-year spread becomes the more telling signal.  With this spread falling and recently hovering around 1%, it is definitely worth taking notice and should at least put up a caution sign.  

If we look at a longer-term chart (below) of the U.S. 10 and 2-year BYC, perhaps it can help us determine where we are at in the current cycle.  Are equities on borrowed time or is there still more upside?  The last two times the spread fell to 1% was in 1995 and in 2005, and in both of these cases there was substantially more upside as equities performed very well from 1995-2000 (especially this time frame) and from 2005-2007.  

 

 

                                            Source:  Thomson Reuters datastream, Canaccord Genuity estimates

 

So although this flattening BYC is definitely a cautionary signal of slow growth, it may also signal a period of strong equity performance ahead as it did in the last two instances. At Milestone, we have our own composite score model that looks at various reliable leading indicators (some economic/fundamental and some technical in nature), of which the BYC is one of them.  At this point, our model has yet to signal a high probability of U.S. recession in the near-term, but we will continue to monitor it closely.