Beware misreading inverted yield curve

Pessimism about growth ignores major growth drivers such as solid labor market

Mar 25, 2019 @ 12:38 pm

By Mohamed A. El-Erian

At the end of last week, the three-month Treasury bills' yield rose above the yield for 10-year Treasuries for the first time since 2007, prompting warnings that the U.S. is headed for recession later this year or in early 2020. That's because, historically, such "curve inversions" have tended to precede major economic slowdowns by about a year. Yet, for reasons that relate both to the current determinants of the yield curve and the underlying state of the economy, the latest curve inversion could prove to be an exception to the rule — unless a misreading creates a detrimental self-fulfilling prophecy.

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Yield-curve inversions are unusual because they involve lenders being willing to earn less interest income on money they commit, and therefore underpin both credit and liquidity risk, for longer. This typically happens when investors expect that yields on shorter-term maturities will fall substantially as the Federal Reserve cuts rates, also potentially dragging down longer-term bonds. This is most likely to occur if the economy is slowing sharply and faces a meaningful risk of recession.

The U.S. economy already has slowed from the average growth rate of 2018, mainly as a result of two self-inflicted wounds: Fed miscommunication and a 35-day partial government shutdown. Even with those two wounds now healing, some economists predict slowing into the rest of the year on the basis of the weakening of the one-off effect from the tax cut stimulus. Also contributing is that the current expansion – already the second longest on record for the U.S. – faces headwinds from trade tensions with China, political uncertainties, and a world that is slipping into greater fragmentation and polarization.

But this pessimism about growth ignores the fact that a solid labor market continues to underpin consumption, the most important driver of U.S. economic activity. Average monthly job creation remains well above what would be expected so late in the cycle. Moreover, more workers have been attracted back into the labor force, expanding productive capacity and income generation. And the current level of wage growth — an annualized rate of more than 3% — entails gains in real as well as nominal terms

Consumption isn't the only driver. U.S. growth this year and next will also benefit from rising business investment. And while the effects of the tax cuts are diminishing, they are being offset by higher government spending.

This rather benign economic outlook conflicts with the traditional signal of an inverted curve for four main reasons:

In contrast to the U.S., Europe is in the grips of a major economic slowdown that could drag the region's growth rate to below 1% this year, heightening the risk of "stall speed." This was highlighted again on March 22 by worrisome Purchasing Managers' Index numbers for Germany and France, the region's largest economies, which contributed to another sharp fall in yields on government bonds as the German 10-year yield went negative. It inevitably puts downward pressure on U.S. yields given global interconnected markets and investment flows. Last week, the Fed went beyond market expectations by solidifying a remarkable and rapid U-turn in monetary policy. The central bank's signal that there would be no rate hikes this year opened the door for markets to expect a cut as early as December. Adding to the downward pressure on yields, the Fed also announced that it would stop its balance-sheet reduction process before markets expected – meaning that more bonds would remain out of the marketplace. Other segments of the bond market are not signaling a major economic slowdown. That includes corporates, where both investment-grade and high-yield indexes are trading at relatively tight spreads. Finally, the erosion in inflationary expectations may have less to do with the anticipation of sharply weaker demand ahead and more with the realization that many of the underlying drivers are structural in nature and secular in duration.

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All of this suggests that, when it comes to the direct economic and markets effects, this curve inversion is unlikely to be the traditional signal of a U.S. recession. But that doesn't mean policy makers should relax. Instead they should be even more motivated to press forward with pro-growth measures such as infrastructure modernization and rehabilitation as a means of reducing the risk of self-fulfilling expectations operating through the financial asset channel.

Already on March 22, the three major U.S. equity indices slumped 1.8% to 2.5% as, according to Bloomberg, "the terms 'Recession' and 'Yield curve' spiked on Google Trends." The more people misread the yield-curve inversion as a signal of looming recession, the more stocks are likely to fall and volatility to rise, and the greater the risk of pockets of market illiquidity. All of these, if sustained, could dampen household and business confidence, postpone business investment decisions, and pull the rug out from under growth.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include "The Only Game in Town" and "When Markets Collide."


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