Stockholm (Ekonamik) – Beyond the insights we have uncovered this week about green bonds and high yield markets, we could not resist taking a look at the yield curve this week. There are two good reasons for this. First, the yield curve has inverted and is sloping downwards again (pictured above). We resisted discussing the curve in March as it was only just starting to turn negative and did so for the first time in the cycle, but as the recent pushes towards negative territory are likely to gain momentum, the timing seems right. Second, we came across a fascinating article from the CME group that reports on a relationship between the yield curve and the VIX, which they argue provides a good map to the business cycle.
The Power of the Yield Curve
After bottoming out at -0.05% at the end of March, the spread between the 10-year US Treasury bond rate and the 3-month US Treasury bill rate, known as the term spread of the yield curve, returned to negative territory again during May. After spending all of April in the green, the yield curve turned south on April 13th, on April 15th and again on April 23rd, when it closed at -0.01%, -0.05% and -0.06%.
The reason we care about downward-sloping yield curves is that there is voluminous evidence suggesting that inverted yield curves signal recessions dating back to Estrella and Mishkin’s 1996 seminal research. Clearly, the term spread alone is not sufficient to accurately predict recessions. However, once it is contextualised and incorporated into a wider trend over a range of variables including short rates, excess bond premia and consumption, there are indications that the model’s performance improves.
As Richard Bernstein of Richard Bernstein Advisors recently commented to Blackstone‘s Chief Investment Strategist Joe Zidle on the asset manager’s podcast, there are three general characteristics he looks at when considering impending recessions. “Number one: are we entering a profits recession – negative earnings growth out of the S&P? Number two would be an inverted curve starts telling you that the credit cycle is shutting down. Many people would argue that credit is the lifeblood of the economy so when you shut that down, you slowly but surely start shutting down the economy. Finally, you want to see people as bullish as possible.” As the advisor notes, of those conditions, only the last one seems to be present, but as Berstein says, “people seem bullish, but they are not euphoric”.
Nevertheless, the variable is prominent enough that the New York Fed publishes a monthly review of its evolution and the probability of recession implied by a probit model of the slope of the yield curve. As of April 2019, the model implied a 27.5% probability of a recession in the next twelve months.
The Yield Curve and the Business Cycle
Insights from the CME Group about the cyclical nature of the relationship between the yield curve and the VIX adds further weight to the evidence that the yield curve is signalling tougher times ahead. In a research note from February, Erik Norland, Executive Director and Senior Economist of CME Group, identifies four stages to this cycle: recession, early-stage recovery, mid-stage expansion and late-stage expansion. In this process, the yield curve begins moving from flat to steep (upward slope) with relatively high equity volatility. Then as “yield curve remains steep, equity volatility begins to fall.” Eventually, “the yield curve starts to flatten, equity volatility remains low”. Finally, the yield curve flattens even further and “equity volatility soars as fears of recession dominate investor behaviour.”
His methodology is relatively easy to replicate, so we did just that and updated his February insights with the latest 3 months of data (orange part of the curve). The data suggests that we have moved just as the CME economist expected and that we are indeed in the “late-stage expansion” phase of the cycle.
One should bear in mind that while the existence of an economic cycle is beyond doubt, history is covered in the destroyed reputations of historians, sociologist, economists and financial analysts who have sought to find a repeating pattern of time to its evolution. However, we do find the relatively nuanced and yet clear view provided by the relationship above saves it from such traps and making it a good guide of where we stand in the business cycle.
Taken together, we believe that these insights all consistently point towards the end of the business cycle and an upcoming economic slowdown, despite recent accommodative moves from the Fed.
Only time will tell, but we think the writing is on the wall.