Chart of the Month – «If you ask me anything I don’t know, I’m not going to answer» Yogi Berra

Chart of the month «If you ask me anything I don’t know, I’m not going to answer» Yogi Berra

And yes, here we go again with one of Yogi Berra’s insightful quote, which, this time, applies for the fate of the economy. It’s anybody’s guess today to give an indication of where the global economy is headed for the next 12 to 24 months, which should not come as a surprise considering the multiple unknowns ahead of us.

First come, first serve, the Covid crisis seems far from abating and its consequences, although now roughly measurable for its first wave, are as opaque as the horizon on a foggy day on Golden Gate Bridge when it comes to its second wave. The outcome of the US elections will have an influence on the US and the global economy (tax increases, domestic stimulus); how will the European economy get out of the current dire straits in which it is stuck; what happens next with the immense amounts of liquidity and debt generated since the start of the crisis; what are the next steps in the China-US economic war; and the list goes on.

Equity markets seem so far to give hope a chance as they’ve recovered sharply from the March lows, but we know things can revert very fast and, amidst this stock prices recovery, there has been an extreme differentiation between sectors, which means that the global picture isn’t that clear for investors.

There’s a very silent economist, who very seldom appears, and whose message is almost always accurate: that’s the US yield curve, and in particular the 3 month-10 year steepness.

Does the US yield curve know something we don’t, as it did many times in the past?

There have been 8 recessions in the US since 1969, including the current one. These 8 recessions had been announced in advance as shown on the table above by an inversion of the 50 days moving average of the US 3month-10 years yield differential (i.e. 3 month rates exceeding 10 years rates).

Very few paid attention to 2019’s inversion which happened in a buoyant mood for equity markets and, frankly, no cloud sufficiently big to make anybody contrarian enough to predict a recession in 2020. And this recession happened, for exogeneous factors (COVID-19) which, mid-2019, was totally unpredictable!

Now the good news, if we believe in the predictive power of the yield curve: it reverted into positive steepness in December 2019, and is now at its steepest point since then with a 57 basis points difference.

So if you’re questioned about something you don’t know, say the economy (nobody can predict the economy), you’re not going to answer; but the yield curve will. And today it’s a positive message.

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Chart of the Month – What’s going on?

Chart of the month

What’s going on?

The US yield curve is flattening at a steady pace. One of the most followed indicators, the 2-10 year differential, has more than halved since the beginning of the year, from 125 basis points to less than 60 bps today.

Traditionally, a flattening yield curve is a warning signal for lower economic growth, and in some cases, notably when it gets into negative territory – i.e. an inverted yield curve – for a recession. Although we’re not in that situation, this rapid flattening of the 2-10 year slope raises questions, especially when all lights seem to be flashing green: global economic growth is strong, Europe and Japan show at last real improvements, Emerging Markets and China are roaring ahead, US employment is extremely steady, and the list goes on.

Besides all these positive indicators, it is also noteworthy that, apart from Venezuela or Turkey, there is no imminent catastrophe looming, at least apparently.

So what is the US yield curve telling us or, in other words, is there something we should really worry about?

First of all there are technical reasons for this flattening: the Fed has announced it will raise interest rates as soon as December this year, with further hikes planned next year, which exerts upside pressure on 2 years yield, while at the same time, tame inflation figures tend to put opposite pressure on longer term yields. The fact that the Fed has also declared that QE was now behind us should eventually have increased prospects for higher long term yields, but the Fed was and is not – by far – the only buyer of long dated Treasuries and strong hands have been on a buying spree of late: foreign holdings of US Treasuries have increased by more than $ 300 billion this year, led by China in particular.

Then, in a world craving for yield, getting 2.5% on one of the safest and most liquid assets in the world (the US 10 year T-notes) is clearly attractive. There is almost no equivalent in the developed world, and perhaps the most strikingly comparable comes with Portuguese 10 year yields which barely reach 1.9%!

But let’s not be complacent; most US recessions were preceded by a yield curve inversion with a negative 2-10 year slope. As we get closer to zero, more and more investors will start fretting about a possible recession and become more cautious. Although we’re not in the recession camp as we see no signs of it in today’s markets and economy, we’ll keep on closely following any deterioration in what could be qualified as a Goldilocks environment. For the time being, enjoy strong equity markets, but don’t overlook the possibility that something bad and unpredictable happens….