Philip Lawlor, managing director, head of global markets research
The inversion of a widely watched part of the US Treasury yield curve last week has rattled markets already nervous about slowing global growth. Such events warrant attention given their recession-predicting history. But the macro and monetary forces driving the recent inversion differ starkly from those in 2006, the first of such inversions preceding the last recession.
Understanding these differences matters for markets struggling to decipher what this signal is telling us.
Global yield curve compression – turning Japanese
Last week, renewed US-China trade tensions and worrying data from Europe and China ignited recession fears, fueling a global flight to safety that sent the 10-year US Treasury yield below the two-year yield for the first time in more than a decade.
The US inversion follows a massive, yearlong compression in yield curves across the developed world as markets have digested the gradual downshifting of the global economy and below-target inflation.
The chart below shows how global yield curves have converged with those of Japan over the past few years.
Big differences between the 2019 and 2006 inversions
In 2006, bond yields were rising. As the chart below shows, two-year Treasury yields rising faster than 10-year yields produced the 2006 inversion (a bear flattening). Both yields continued to climb thereafter, ultimately reaching just above 5% (see chart below). The opposite—a bull flattening—has driven the 2019 inversion. This is when long-dated yields fall faster than short-dated yields. Bear flattenings have been the more common causes of past yield-curve inversions.
Financial conditions were tightening in 2006—they’re easing today
The Fed kept hiking rates after the 2006 inversion. That’s not the case today. The Fed stopped tightening eight months ago and markets are forecasting another three to five 25-basis-point cuts to the end of 2020. Indeed, our aggregated Financial Conditions Indicator for the US has fallen steadily since peaking last November, from what would be deemed as tight (approaching 4) to below 3, or levels viewed as accommodative.1 Following the 2006 inversion, the US FCI score climbed into "tight" territory following the 2006 yield-curve inversion.
Growth outlook remains anemic
As the decomposition chart below illustrates, anxieties about economic growth prospects (as indicated by the sharp pullback in real yields) are wholly behind the steep declines in nominal US, UK, German and Japanese bond yields since their January highs—not inflation expectations.
Low nominal yields (not inversion) are the more significant economic signal
By our reading, the August 2019 inversion is about the transition to lower trend growth; the 2006 inversion was signaling over-tight financial conditions. Nominal bond yields are reflective of longer-term trend nominal GDP growth expectations (factoring in a term-premium assumption). The sub-2% bond yields in 2019 (as compared with 5%-plus yields in 2006) are telling us something about the regime shift in growth expectations that has unfolded over the past year.
1 To gauge the extent of changes in financial conditions across the regions, we use a Z-scoring methodology that compares the current reading of each variable against its longer-term average, measuring these divergences in terms of standard deviations, which are clustered into bands 1 (loose) through 5 (tight).
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