SINGAPORE (May 13): In Westeros, the setting for HBO’s smash fantasy TV show Game of Thrones, seasons can last for years, even generations. The series begins at the end of a nine-year-long summer, with Westeros’ residents having grown fat off the bounty of the land. But winter is coming, as it always does. An age-old threat rises again from the icy lands of the North, and those who are unprepared will perish.
For the global economy, summer has lasted even longer than in Westeros. We have gone without a global recession since 2009, and investors have reaped the rewards of one of the longest economic expansions in history. Surely this cannot last, many say. A recession must be around the corner.
On March 22, something rare and momentous happened that seemed to confirm these fears. The yield on 10-year US Treasuries fell below the three-month T-bill yield for a few days. This event, known as a yield curve inversion, has preceded every one of the seven recessions since 1950, according to the San Francisco Federal Reserve’s 2018 article, “Economic Forecasts with the Yield Curve”. Yield curve inversion is therefore closely watched as a recession indicator.
Why should yield curve inversion be linked to recessions? Typically, long-term interest rates are higher than short-term rates because risks and uncertainty are higher over a longer time horizon. Investors therefore demand higher rates to compensate. This is known as a positive term spread. When inversion happens — that is, when long-term rates dip below short — it means that investors are expecting interest rates to go down in the future. This can happen for many related reasons, but most of them point to a recessionary period where interest rates need to be cut to support economic growth.
As a rule of thumb, yield curve inversion happens 12 to 24 months before a recession, which implies that we should be expecting one soon. For example, the most recent yield curve inversion happened in July 2006 (see chart). The economy went into recession 17 months later in November 2007 — a deep and painful one that lasted until 2009.
Although inversions have preceded every recession, it does not mean that recessions must occur after every inversion. This is a crucial distinction. For example, in late 1966, there was a “false positive” in the sense that the yield curve inverted but no recession took place within 24 months. So, the yield curve is not a perfect predictor of recessions. After all, there is no magic in the yield curve — it simply measures bond investors’ interest rate expectations over different time periods. So, really, what we are saying — by investing the yield curve with oracular powers — is that bond investors as a whole are especially good at predicting recessions compared with other forecasters. But why should this be the case?
Also, one has to wonder to what extent this is simply about data mining. There is no good theoretical reason that yield curve inversion should be measured by the spread between three-month and 10-year rates. Why not one-month versus five-year rates? Especially with such small sample sizes, it is easy to try different combinations of term spreads until we find one that “works”, but that does not necessarily mean there should be any special significance attached to a three-month and 10-year term spread in particular.
We should also note that the term spread has been close to zero for quite a while before turning negative. A small change in rate expectations, leading to a small inversion, should not lead to a step change in recession expectations. The yield curve may indeed be associated with recessions, but we should take its predictive powers with a pinch of salt.
So, is winter really coming? Or, more usefully, is winter coming within the near future, given how long the global economy in general has been expanding? Janet Yellen, then chair of the US Federal Reserve, famously said in her Dec 15, 2015 press conference, “I think it’s a myth that expansions die of old age”. Many economists have spoken up in agreement with her, and many disagree. The truth is that no one has found a convincing theory that can predict when expansion falls into contraction, because recessions happen as much because of expectations as because of reality. When consumers expect a recession, they cut back on spending, starving businesses, which in turn affects profits, investment and employees (who are themselves consumers). No discussion on recession “prediction” can be complete without accounting for economic sentiment, which is tricky to forecast and not always based on fundamentals.
In my view, there are two key considerations. The first is that more and more market actors are expecting a recession as the economic expansion drags on. Counterbalancing this is the willingness of the central banks, especially the Fed under Powell, to be more accommodative and avoid raising interest rates too aggressively, which could tip the scales towards a recession, while avoiding runaway inflation. No one can tell when the balance between the two forces will shift, but it is unlikely that they can remain balanced forever. The more nervous people are, the more likely a recession will happen. In this context, the yield curve inversion might turn out to be a self-fulfilling prophecy because of its influence on recession expectations.
For investors, I urge you to see past this noise and stay invested, at least for now. It is impossible to predict when the recession will hit, or whether prices will end up much lower than today when it does — after all, valuations are not ridiculously overstretched and sentiment is not frothy. Winter will come at some point, but so must spring. Save yourself the angst — look past the volatility and focus instead on harvesting long-run equity returns.
Herbert Lian is a financial adviser representative at IPP Financial Advisers Pte Ltd. The views expressed here are solely those of the author in his private capacity. This article should not be regarded as professional investment advice or as a recommendation regarding any particular investment.
