Over the years, I’ve learned what investors tend to ask when they start to
get nervous. And one popular question that often comes up during client
meetings is, “What indicators are the best predictors of recession?” My top
three indicators include these: a widening of high yield credit spreads;
consecutive negative readings in the Chicago Fed National Activity Index;
and a negatively sloped, or inverted, yield curve.
While credit spreads and leading indicators appear to be fairly well
behaved, many have noted the sinister-looking shape of the yield curve,
near its flattest level since before the global financial crisis (see the
chart below). Although this flattening has contributed to concerns of an
impending economic slowdown, a flat curve alone doesn’t necessarily spell
Instead, the yield curve typically has to invert (when long-term bond
yields fall below short-term yields) in order to presage a recession. Curve
inversions are worrisome because of their potential to constrain lending,
which in turn curtails economic growth. Banks find it less advantageous to
lend when their own cost of borrowing is above their cost of lending.
However, a mere flattening of the curve is not as concerning.
Likewise, historical curve inversions have also been associated with sharp
declines in stocks, given the risk to earnings when the economy hits the
skids (see the chart below). Markets are not impervious to risk-off
episodes when the curve is positively or normally sloped, but the magnitude
and duration of the downturn is much more muted.
Putting the recent market indigestion into context, the positively sloped
yield curve offers some comfort by suggesting the selloff may be
short-lived and could be an opportunity to take advantage of cheaper
So the question remains: Although the curve doesn’t appear to be at a
disconcerting level, could it invert anytime soon? Recently, short-term
rates have risen as a growing number of central banks reverse their overly
accommodative monetary policy in response to better economic conditions.
That said, curve inversions tend to coincide with a shift in the
macroeconomic regime and a peaking of short-term interest rates. We still
see the world being in the very early stages of monetary policy
normalization, with the closing of output gaps having been slow and
gradual. Meanwhile long rates are finally beginning to nudge higher despite
demographic trends, structurally elevated risk aversion, stubbornly low
inflation, strong institutional demand for long-dated bonds and
quantitative easing (although less relevant to Canada).
If historic trajectory and pace of flattening tells us anything about the
future, it’s that the curve could continue to steepen before flattening
further. In fact, we may be starting to see exactly that.
In the first five weeks of 2018, the Canadian and U.S. yield curves have
actually steepened from the December lows amid rising inflation
expectations, a repricing of monetary policy expectations, the passing of a
potentially game-changing U.S. tax reform bill and other fiscal stimulus
measures, and heightened optimism around the progress of NAFTA
negotiations. The path to an inversion isn’t perfectly linear, nor do
curves invert due to old age.
We see this equity market selloff as a potential opportunity to buy on dips
given our broadly supportive outlook for the economy and earnings. We
continue to favor equities over bonds, especially non-U.S. international
exposure, given our broadly supportive outlook for the economy and
earnings. While the slope of the yield curve today may point to more modest
returns in future years, we believe the bull market still has room to run.
Director, is BlackRock’s Chief Investment Strategist for Canada and is
a member of the BlackRock Investment Institute (BII).
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