#Market Strategy — 15.08.2019

Yield Curve Inversion Triggers Recession Fears

Prashant Bhayani & Grace Tam

The US 2-10 year yield curve is one of the most widely followed recession indicators, but is it still a valid signal?

yield curve inversion clarity

The rally of the long-end US Treasuries last night led to a brief inversion of the US 2-10 year yield curve, the first time since 2007. The 2-year and 10-year yields finished the day at 1.577% and 1.581%, respectively.

The US 2-10 year yield curve is one of the most widely followed recession indicators, as it has indicated a looming US recession in the past. However, as the US yield curve may be distorted by QE (quantitative easing), whether this is still a valid signal of recession is a question mark.

The spread between US 2-year and 10-year yields falls to a mild negative. But quantitative easing (QE) has distorted the yield curve, is it still a reliable signal?    

Yield Curve Inversion

Spread between 2-year and 10-year yields

Source: Bloomberg, BNP Paribas WM, 15 August 2019

At the same time, despite the stronger-than-expected UK CPI inflation data, the UK 2-10 year yield curve also inverted yesterday amid growth concerns, which has been complicated by the Brexit uncertainty.   

Combined with the weaker-than-expected economic data from China (sharp deceleration in industrial production and retail sales growth in July) and Germany (2Q GDP contracted 0.1% qoq), risky assets took flight as a result, with the S&P 500 and the Euro Stoxx 50 falling 2.9% and 2.0%, respectively.

Yield curve inversion doesn’t imply an imminent recession

Historical data (table below) shows that after the 2-10 year yield curve inversion, the S&P 500 reached the peak in 13 months on average and US economy entered recession in 21 months on average thereafter.

Historical 2-10 year yields

Historical 2-10 year yields vs S&P 500

Source: Bloomberg, BNP Paribas WM, 15 August 2019

No doubt that recession risk is rising amid further escalation of trade conflicts, which will have negative impacts on global growth. Our base case scenario is still a global synchronized slowdown this year, rather than an imminent recession.   

Markets are currently pricing in a significant probability of 50bps cut by the Fed in September. We have been seeing a global synchronized rate cuts since the Fed cut in July. This could serve as a cushion to the downside risk, although it is arguable that global monetary easing is a cure to slowing growth. Fiscal policies are needed to revive growth.   

Investment implications

We still maintain our short-term negative view on global equities given the growth concerns and plenty of uncertainties around (trade war, Brexit, political events). Also, valuations, especially US equities, have yet to correct enough to look attractive.

As we recommended since early May this year, a healthy portfolio diversification is important to navigate the sea of volatility. We remain positive on gold and short-end US Treasuries. The defensive high dividend stocks and selected Asia credit have also been relatively resilient.