The beginning of the year’s sharp rise in interest rates has finally given a jolt to stocks. Although the rise in interest rates is, in many ways, confirmation of a better economic environment, it has prompted many economists to revisit their forecasts.
Over the years, I’ve learned what investors tend to ask when they start to get nervous. And one popular question that often comes up during client meetings is: “what indicators are the best predictors of recession?” My top three indicators include: a widening of high yield credit spreads; consecutive negative readings in the Chicago Fed National Activity Index; and a negatively sloped, or inverted, yield curve.
While credit spreads and leading indicators appear to be fairly well behaved, many have noted the sinister looking shape of the yield curve, near its flattest level since before the global financial crisis (see the chart below). Although this flattening has contributed to concerns of an impending economic slowdown, a flat curve alone doesn’t necessarily spell trouble ahead.
Instead, the yield curve typically has to invert (when long-term bond yields fall below short-term yields) in order to presage a recession. Curve inversions are worrisome because of their potential to constrain lending, which in turn curtails economic growth. Banks find it less advantageous to lend when their own cost of borrowing is above their cost of lending. However, a mere flattening of the curve is not as concerning.
Likewise, historical curve inversions have also been associated with sharp declines in stocks, given the risk to earnings when the economy hits the skids (see the chart below). Markets are not impervious to risk-off episodes when the curve is positively or normally sloped, but the magnitude and duration of the downturn is much more muted.
Putting the recent market indigestion into context, the positively sloped yield curve offers some comfort by suggesting the selloff may be short-lived and could be an opportunity to take advantage of cheaper valuations.
So the question remains: Although the curve doesn’t appear to be at a disconcerting level, could it invert anytime soon? Recently, short-term rates have risen as a growing number of central banks reverse their overly accommodative monetary policy in response to better economic conditions. That said, curve inversions tend to coincide with a shift in the macroeconomic regime and a peaking of short-term interest rates. We still see the world being in the very early stages of monetary policy normalization, with the closing of output gaps having been slow and gradual. Meanwhile long rates are finally beginning to nudge higher despite demographic trends, structurally elevated risk aversion, stubbornly low inflation, strong institutional demand for long-dated bonds and quantitative easing (although less relevant to Canada).
If historic trajectory and pace of flattening tells us anything about the future, it’s that the curve could continue to steepen before flattening further. In fact, we may be starting to see exactly that.
In the first five weeks of 2018, the Canadian and U.S. yield curves have actually steepened from the December lows amid rising inflation expectations, a repricing of monetary policy expectations, the passing of a potentially game-changing U.S. tax reform bill and other fiscal stimulus measures, and heightened optimism around the progress of NAFTA negotiations. The path to an inversion isn’t perfectly linear, nor do curves invert due to old age.
We see this equity market selloff as a potential opportunity to buy on dips given our broadly supportive outlook for the economy and earnings. We continue to favor equities over bonds, especially non-U.S. international exposure, given our broadly supportive outlook for the economy and earnings. While the slope of the yield curve today may point to more modest returns in future years, we believe the bull market still has room to run.