The yield curves on the global bond markets flattened dramatically during the second half of October. When flattening is followed by inversion of the yield curves, a recession is inevitable. This ominous development is causing concern in the market, but are the concerns justified?
Scientific research shows that yield spreads are established indicators of recessions. On average, the yield curve is slightly upward sloping and concave. When this curve flattens or inverts - the situation where 10-year bond yields are lower than shorter-term bonds - a recession is usually inevitable. Over the past 50 years, recessions have almost always been preceded by a flattening and eventual inversion of the curve.
In fact, a European Central Bank (ECB) study released in November found that credit growth and the slope of the yield curve are the most important predictors of an overall economic crisis, both domestically and globally. “A flat or inverted yield curve is most worrisome when nominal interest rates are low and credit growth is high,” the ECB said.
According to Clemens Kool, Professor of Macroeconomics at Maastricht University, there are three arguments in favour of the flat or inverted yield curve as a predictor of recessions.
First of all, a net flat curve reduces the net interest margin of banks, which puts pressure on profitability. This can lead to a lower supply of credit and subsequently an economic dip. Also, a flat curve can indicate low risk premia (low long-term interest rates), causing investors to shift to riskier investment products, resulting in fragility and crisis.
If the flattening is caused by the rise in short-term interest rates, it could also be monetary policy that triggers the turning point itself by tightening to combat a boom, according to Professor Kool.
That flattening now seems to have started. In the second half of October, the difference between long-term and short-term government bond yields in the major developed economies narrowed dramatically. This ominous development is now attracting the attention of all parts of the financial world. Bond investors in particular are on the ball. Is there cause for concern?
Aegon Asset Management
Hendrik Tuch, head of fixed income at Aegon Asset Management, estimated that the US curve will invert in 2023 or 2024, with Europe to follow. “When that happens, it’s always a hit - we’ll plunge into recession,” he told Fondsnieuws, Investment Officer Luxembourg’s sister publication. “But first we will see a winding down of the purchase programmes and a number of interest rate increases that will not put the brakes on the economy at a moment’s notice.”
“Both in Europe and America, the long end of the curve collapsed completely in October,” Tuch continued. “Long-term interest rates in America had been falling for months, despite the fact that inflation has risen enormously and share prices are continuing to rise. The fall of long-term interest rates is weird.”
Tuch said he was shocked by the sharp flattening of the European curves. “Like many other investors, we were using so-called ‘steepeners’, a strategy where derivatives are used to take advantage of escalating yield spreads between two bonds with different maturities. Investors got out of this strategy in droves, so we decided to take our chances. We sold our steepeners and neutralised the curve positions.”
“Now we are responding to the flattening by going short on two-year US government bonds (65 basis points) and we are going long via futures on the US 30-year government bonds (186 basis points). With this popular trade you have a duration-neutral position, it does not matter if the yield curve goes up or down. As long as the curve flattens, you’re in the clear.”
Achmea
According to Rob Dekker, senior portfolio manager fixed income at Achmea, yield curves are “currently a lot flatter than usual in this phase of the economic cycle. Logically, this is keeping the market quite busy at the moment.”
Dekker said he shares Tuch’s analysis that investor’ positioning in steepeners has largely contributed to this. At the beginning of the year, long-term interest rates rose, while short-term interest rates remained steady. This was because central banks did not want to do anything about inflation because it was seen as “temporary”. Long-term interest rates rose because there was an economic recovery and inflation expectations rose slightly. Such a steepening is a logical phenomenon after a crisis.”
Dekker continued: “However, we saw quite a substantial movement in the curve in October. Because central banks had been saying for a long time that they would not do anything, a lot of investors were sitting in steepener positions. When the curve started to flatten, most of them left those positions, which further accelerated the flattening. So positioning is an important reason for the developments we are seeing now.”
Recession still far off, but stagflation not unthinkable
According to Dekker, a recession is still a long way off because the yield curve still has to invert after the flattening. Stagflation, on the other hand, is a scenario that investors should seriously consider, he said. “If you look at how the market is now approaching the inflation scenario, we see that stagflation is being priced in. Central banks are in a difficult position.”
“The curve is too flat now and inflation is high. But if they start doing something about it now, you will see that growth will be lower in the long run. In January, many countries will come to the market with new loans, but our expectation is that there will be less buying by the ECB towards March. That will lead to slightly higher interest rates and a steeper curve. The obvious thing to do then is to sell part of the duration to reduce the portfolio’s interest rate sensitivity,” said Dekker.
“Nevertheless, the curve will not move much more in the period thereafter and interest rates will not rise further. The central bank will not stoically weaken growth by raising interest rates too quickly. If central banks pay attention, the chance of a recession in the foreseeable future is small,” Dekker concluded.
Tuch said he believes that the market should not underestimate how much central banks are still buying up. “Although the Fed and the ECB want to cut back, cutting back still means expanding. They are also still reinvesting a lot. The ECB announced in the press conference after the last meeting last Thursday that it will buy much less next year, but it will still buy a large proportion of all European bonds in the secondary market, among others.”