To my clients:

It was a down week for North American stock markets with the Canadian TSX finishing down 0.4%; the U.S. Dow Jones Index finishing down 0.3%; and the U.S. S&P 50 finishing down 1.3%.

This week’s update will be different than most as I will be leveraging off of an RBC publication and conducting a deep(ish) dive into inverted yield curves. I’ll be doing so because this topic has been front and center in the business press and I have received a couple of client inquiries on the topic. I readily acknowledge that many clients may not want to join me on this dive, and if that’s you, feel free to skip this week’s update. But if you are interested in what all the hubbub is about, read on. I’ll do my best to translate the jargon used in the RBC piece into language readily accessible by most clients.

So before digging into the nuances of the topic, let’s begin by answering three core questions first:

1) What is a yield curve inversion? Answer: a yield curve inversion is when short-term interest rates rise above long-term rates. I’m sure all would agree that this is a strange circumstance. We all know that if we buy a GIC or bond, we normally expect to receive a higher interest rate for the longer terms we might select. But when a yield curve inverts, it effectively means that short term 1-year bonds, for example, pay an investor a higher rate of interest than, say, a 5-year bond. Weird, right?

2) Why does a yield curve invert? Answer: yield curves invert when expectations for future economic growth are less than present short-term interest rates.

3) What is RBC’s core thesis? Answer: that recent discussions of yield curve inversion as a predictor of recessionary risk have gotten ahead of the data and the economics.

Ok, with the basics addressed, let’s dig in….

A yield curve inversion has occurred before the start of every recession for the past 75 years. Further, RBC research has shown that every bear market (i.e. sustained stock market losses of greater than 20%) has been associated with a U.S. recession. On average, an inversion has arrived 11 months before recessions and nearly six months before stock market peaks. Given this track record, it’s perhaps understandable that the financial and popular press have now latched on to the measure and routinely cite relative interest rate levels when predicting an “imminent” and “inevitable” recession.

But much of the recent reporting has failed to consider the economic logic behind the indicator’s predictive power, and RBC believes the result as reported in the popular and business press is a flawed interpretation of the current recessionary probability in the U.S.

Most notably, it is very important to understand that not all yield curves are created equal. Almost all of the recent commentary discussing yield curve flattening and inversion has focused on the difference between the 2-year and 10-year yields; almost none has focused on the difference between 3-month borrowing rates and 10-year Treasury yields. On the one hand, this is not surprising: the 10-year vs. 3-month yield is nowhere near inversion and has been steepening—not flattening—of late. This doesn’t make for great headlines in the press. Yet on the other hand, this avoidance of the 10-year vs. 3-month difference is very surprising: after all, that measure of yield curve steepness forms the basis of most academic research on recession prediction and—not coincidentally—serves as the Federal Reserve’s preferred measure of the yield curve.

There is an economic logic behind the Fed’s focus on the difference between 3-month and 10-year maturities (versus the Press’s focus on the difference between 2-year and 10-year yields). Specifically, bank loans form a significant part of the capital structure of many corporations and these are typically linked to short-term borrowing rates such as the 3-month yield. The 10-year yield serves as a reasonable proxy for market growth expectations. So, as 3-month rates rise above 10-year yields, we would not be surprised to see corporate executives shelve spending plans until growth expectations recover, and instead use the funds to pay down short-term loans. This would tend to constrain growth in the economy overall, providing much-needed logic to how a flattening yield curve connects to recession probability. But this connection is often glossed over, or missing entirely, when the press discusses flattening between other points on the yield curve.

Now, one potential drawback to using the 3-month rate as the basis of curve measurement is that it’s slow to adjust when the Fed signals a major shift in interest rate policy such as we are witnessing right now (i.e. the Fed has strongly signaled that interest rates will be significantly higher by year-end than they are now). For this reason, many bond trading desks prefer to look at the 2-year vs.10-year Treasury yield when discussing inversion, arguing that the 2-year better incorporates market estimates of where short-term interest rates are headed and can give an earlier signal of a potential upcoming recession. On the surface this makes some sense. However, one obvious problem with this approach is the difficulty of predicting exactly what future Fed policy might be; after all, few, if any, bond market watchers predicted the last two years of monetary policy.

For RBC’s part, we use the difference between 1-year and 10- year government debt as a compromise between the two approaches. By confining ourselves to the next 12 months, we have better visibility on potential Fed changes, while still generating a signal that has led recessions and significant market downturns by nearly six months on average. We then incorporate this yield curve measurement into our 7-point U.S. recession scorecard (which I have cited many times in these weekly updates), which includes this and six other key leading economic indicators.

As of the morning of April 7, there is a 0.86 percent positive gap in favor of the 10-year Treasury yield over the 1-year, leaving our measure firmly in what we view as benign territory. If that difference were to narrow to something under 0.3 percent, then we would begin to worry somewhat and would likely shift the yield curve signal in our 7-point Scorecard to a cautionary neutral view (i.e. flashing yellow), and if it were to flip negative—where the 1-year yield exceeds the 10-year yield—we would move this indicator to an outright red on the scorecard. Importantly though, this looks to us to be a long way off as things currently stand.

Yet another factor in yield curve analysis today is inflation. For most of recent U.S. economic history (i.e. the past 40 years), inflation was largely an afterthought for most investors. That is clearly not the case today, with the Consumer Price Index rising at the fastest pace since the early 1980’s. One way to incorporate inflation into our yield curve analysis is to focus on Treasury Inflation-Protected Securities (TIPS), which adjust their cash flows based on changes in consumer prices. These bonds provide us with a so-called “real yield,” (in other words, these securities reveal what an investor’s true, after inflation, interest return might be). By this measurement, rather than being briefly inverted as screamed by the popular press, the difference between the 2-year to 10-year curve is a very healthy 1.37 percent. In other words, far from signaling recession, the TIPS market is indicating confidence in the Fed’s eventual ability to bring prices under control, a view that is confirmed by other inflation indicators we track here at RBC.

Bottom line: we here at RBC remain of the view that we will experience positive, albeit slowing, economic growth in 2022. All seven of our recessionary indicators continue to flash green. That said, we acknowledge higher risks to the expansion particularly in the 2023–2024 time frame. We will, of course, actively monitor these risks. But, at present, given our belief that no recession is imminent, we continue to recommend (and I have positioned clients in) an overweight stance in equities.

That’s it for this week. All the best,

Nick

Nick Scholte, CIM, FCSI

Senior Portfolio Manager

Scholte Wealth Management
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
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