Financial market and commodity price volatility have become more subdued in recent weeks, while bond yields and equity markets have continued to grind higher. The war in Ukraine has now moved into its second month. Some reports have suggested that Russia has begun to narrow its focus to the Eastern regions of Ukraine. The prospects of a more contained and predictable conflict may have contributed to the reduction in market volatility.
The U.S. yield curve has received an excessive amount of attention by most major financial news outlets. What exactly is the “yield curve”? It can be thought of as a series of expected returns (percentage yields) for government bonds with maturities ranging from a few months to thirty years. The yield curve is simply a line that links all of the various yields together.
An upward sloping curve suggests that investors are willing to accept a lower return for bonds that are shorter-term, while demanding a higher return for longer-term bonds to compensate for the extended holding period. The shape of the curve often changes, because bond yields are determined by investor expectations. It is possible for shorter-term yields to be driven higher or lower, while longer-term yields may move to a lesser extent or even in the opposite direction.
The dynamic explained above has taken place to some extent in recent months. Investors have been preparing for central banks to raise short-term interest rates quite aggressively. As a result, short-term bond yields have moved sharply higher. Longer-term bond yields have risen less dramatically, as they are being influenced by expectations relating to a slowing economic growth rate and falling inflation in the more distant future. This divergence over the past few months has resulted in a flattening of the yield curve and, in some cases, an outright inversion where longer-term bond yields have fallen below shorter-term yields.
Why all of the concern about the yield curve? An inversion of the U.S. yield curve has proven to be a useful signal that a U.S. recession may lie ahead. As is the case with most forecasting indicators, there are significant nuances that must to be considered. First, there are yield curves encompassing different maturity time frames. Some yield curves are still upward sloping, suggesting that recession risks remain relatively benign. In addition, there is typically a significant time lag, often well over one year, between a yield curve inversion and a recession. Further, the U.S. Federal Reserve is expected to begin selling bonds as part of its plan to unwind its bond buying program put in place in 2020 to address the pandemic-induced recession. These bond sales will put upward pressure on longer-term bond yields, potentially unwinding some of the flattening of the curve that has taken place.
Our RBC Investment Strategy Committee regularly reviews and publishes a U.S. recession scorecard which consists of seven different indicators, including the yield curve. To-date, none of these indicators are flashing recession warning signs, giving us confidence that it remains premature to be overly concerned. Nevertheless, these indicators can, and will change, over time. For that reason, we continue to be attentive.
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