Earnings estimates for the next 12 months are rising. While stock prices are rising even faster, it’s a signal that a majority of analysts believe the economy is on a fairly steady path forward. And the somewhat higher pricing of course supports that interpretation, with its implication of increased confidence.
Now contrast this with the signal from the yield curve. In the US, it’s been inverted for 21 months in a row, with the Euro count four months behind. Inversion means that the yield on long maturities is lower than the yield on short maturities. Here I’ve used the yield spread between 10-year governments bonds and 2-year government bonds, a common gauge for market participants. Some prefer shorter maturities, but the interpretation remains the same:
An inverted yield curve is “typically associated with a recession in the near future,” according to the Federal Reserve Bank of Chicago. You will find innumerable other papers and articles with similar conclusions and interpretations. Normally, the yield curve is expected to slope upwards, as investors demand a premium for the risk of staying put. When the opposite happens, a recession usually follows. It did in 2020, although I’d be hard pressed to state that the yield curve predicted the pandemic.
How do you define “near future”? A great many papers on yield inversion imply that a recession will occur within a year. Some sketch a span of six months up to two years. Today, apparently, a recession is long overdue or about to be. If you ask the stock market, however, it is definitely not about to happen in the near future. Instead, it’s beginning to look a lot like the fixed income markets are crying wolf.
Here is one way of describing the logic behind using yield curve inversion as a recession indicator: The short end of the yield curve is typically decided or strongly influenced by key policy rates, while the long end of the curve reflects market movements. Thus, when you have a combination of hawkish monetary policy – say, to combat inflation – and pessimistic investors, the curve will invert and a recession is coming.
In my view, the long end is not really left to the market anymore. Even though the Federal Reserve has been selling Treasuries for two years now, reversing a small part of its quantitative easing programme, its holdings of securities ($7,000 billion) are still almost 15 times the level 15 years ago. That’s a large volume of Treasuries being withheld from the market. If the dynamics behind an inverted yield curve have changed, should we expect it to carry the same meaning as before?
Eventually, of course, a recession is bound to occur. That’s a prediction I can safely endorse. But if it takes, say, 26 or 32 months, can we really claim that it was foretold by the yield curve?
That, it seems, is a question most stock investors don’t bother to answer.
Finn Øystein Bergh
Chief Economist & Strategist
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