One of our most reliable, long-leading indicators of U.S. recession—the spread between the 1-year Treasury yield and the 10-year yield—has flipped to negative and is now strongly suggesting a recession is on the way. Another, the Conference Board Leading Economic Index, could do the same within the next few months, while a third, ISM New Orders minus Inventories, moved into the “red” column two months ago. The remaining four are all still firmly positive but moving (slowly) in the wrong direction.
Deepest inversion since 1990. The pace of yield curve inversion has been quite meaningful in the month of July, as the Canada 2s10s spread drops to its most negative level since 1990 at -47bps (-0.47%). South of the border, the US 2s10s spread is hovering at -36bps, its lowest level since 2000.
Source: RBC Wealth Management, Bloomberg
In fact, the 1-year Government of Canada Treasury Bill has now become the highest yielding piece of Canadian government paper at roughly 3.4%, sitting significantly above all other longer dated maturities – nearly 60bps above to 30-year bond rate of 2.8%! This means that from a pure yield perspective, the case to add a lot of duration has become less compelling. That said, if willing to stomach the volatility, and look at things from a total return lens, there is a case to be made for longer duration. Since interest rates and bond prices move in opposite directions and longer maturities are more interest-sensitive than shorter ones, any move lower in rate hike expectations will benefit these longer positions disproportionately more.
Source: RBC Wealth Management, Bloomberg
Over the last couple of months, the market’s focus has shifted away from inflation and towards growth. Since peaking, short- to mid-term rates on both sides of the Canada/US border have fallen sharply, as recession fears prove to be a more influential force for bond prices than inflation. In fact, market expectations for inflation have taken a sharp step back from their March peaks. In our view, these more moderate expectations are expressing two opinions: (1) the central banks can and will succeed at bringing inflation down to target within the next couple of years, and (2) a potential recession will do much of the heavy lifting in terms of the demand destruction needed to ease inflationary pressures.
Source: RBC Wealth Management, Bloomberg
Rather than being panicked about a potential recession, it is our base case that given the underlying strength in the “real” economy (crowded airports and restaurants, record low unemployment rate, strong corporate earnings), any downturn should be relatively shallow. In fact it could be a necessary evil to bring inflation and interest rates back onto a more sustainable path.