‘The US 2- and 10-year treasury yields inverted last week. The bears are saying ‘A recession is coming.’ ‘Correlation is not causation’ retort the bulls. Here’s what investors should know about yield curve inversion.
What is it?
Equity markets do strange inversions many times, like the recent fad for IPOs of new age companies - Higher the unprofitability of new age companies, the higher seemed to be the valuations they got.
Bond markets are, however, more circumspect. The longer the time horizon to get back your money, higher the interest rates an investor will demand. The reason is simple –the longer the duration, the higher the risk in terms of solvency of the borrower, and also in terms of macro risks that can impact the value of your investment. For treasury/government bonds where there is no risk of default as the governments can print currency and repay, the yields usually reflect only duration risk. In terms of macro risks, inflation could be higher 3 or 5 years down the line, and you may want higher interest rates to compensate for that.
Thus the relationship between duration and interest rates (bond yields) is usually straight forward and yield curve (line plot of duration and yield) is typically upward sloping.
However, once in a while, bond investors turn the tables and end up inverting the yields i.e., the yield for 10-year treasury bonds gets lower than the yield for 2-year treasury yields. For example while at present the US 2-year treasury (government) bond is yielding (interest rate/price of bond) 2.46 per cent and 10 year bond is yielding 2.39 per cent , resulting in inverted yield curve. To the contrary, at the start of the year, the 2-year bond was yielding 0.76 per cent and 10-year bond was yielding 1.63 per cent. The difference between their yields which was at 87 bps just three months back, has become negative 7 bps now. Think about this, will you invest in say, a 5-year fixed deposit if it was offering you lesser interest rate than a 2-year fixed deposit? While you would not, the bond investors are doing precisely that.
When does inversion happen?
Typically yield inversion happens when bond investors start worrying about long-term growth prospects. In such a scenario, investors begin to prefer long-term bonds over short-term bonds. This is because if long-term growth prospect does not appear good, it is likely that deflation is a bigger risk and interest rates are likely to move down. In such a scenario, investors will want to buy into longer tenure bonds and lock in the rates those bonds are offering. Besides better rates over the lifetime of the bonds, they will also subsequently benefit from principal appreciation in the bond if interest rates do come down (when yields/interest rates decline, bond prices move up and vice-versa). More preference for longer tenure bonds may result in yield curve flattening/ inverting.
Why is this happening now?
Uncertainties have increased substantially since the start of the year. After indicating in December 2020, the possibility of three small 25 basis points (bps) rate hikes during the course of 2022, the US Fed has now indicated possibility of 7-8 rate hikes with few rate hikes likely to be larger at 50 bps. Balance sheet reduction is also on the cards with Fed expected to move to quantitative tightening versus quantitative easing which has been in place since March 2020. For a US and global economy accustomed to ultra-low interest rates and accommodative monetary policy for more than a decade, it remains to be seen how they can cope with the new order. Adding to this, are the huge uncertainties to global growth caused by the Russia-Ukraine crisis. Increase in supply chain disruption due to the war, higher costs impacting demand, risks of financial contagion due to sanctions on Russia etc. are factors expected to impact growth outlook for the year.
So, is a recession in the US imminent?
Here are the facts – one, every recession in the US since the 1950’s has been preceded by an inverted yield curve; two, it has been a false alarm once; three, yield inversions need to sustain for some time – at least a few weeks to be considered a reliable predictor of recession; and four, the time gap between yield inversion and recession can be as short as few months to as long as around two years based on past trends. Stocks can move up in the interim period between time of inversion and the recession actually hitting the ground.
Further, there are also different views on which yield curve inversion actually indicates that recession is round the corner. While Wall Street is usually more focussed on inversion of 2- and 10-year yields, research by the US Fed indicates that any inversion of 3- month and 10-year yields is a better indicator. Currently the 3-month/10-year yield spread is no where close to inverting. One of the most famous economists of the previous century – John Kenneth Galbraith, is once supposed to have said – ‘The only function of economic forecasting is to make astrology look respectable.’ Thus, given the inherent risks involved in economic forecasting, whether the yield inversion last week is harbinger of recession is a judgement left to time.
Should equity investors in India be worried ?
Recessions in the US have usually been adverse for Indian markets. This time, whether the US ends up in a recession or not, equity investors cannot ignore the fact that bond markets are indicating concerns on long-term growth outlook.
Further, this inversion comes at a time when key indices remain close to peak valuations, and when earnings estimates for India Inc. are getting revised downwards. At the same time, interest rates are likely to move north sooner than later. Thus, two factors that are usually positive for equities – earnings and lower interest rates - are going to trend worse than what was expected at the start of the year. Concerns on inflation and Russia-Ukraine uncertainties are unlikely to get resolved in the near term. In this backdrop, the yield inversion is an incremental reason to get cautious on equities if you are a long-term investor.
More diversification in your portfolio, following a bottom-up stock picking approach and being focussed on value investing is the way forward for current times. A time to get aggressive would come in future. Till then, investors must play to stay in the wicket.