A recession predicted in 2020

There has been lot of excitement in the bond world in recent days. First, the US central bank changed its interest rate policy and, instead of raising rates has cut them. Then the UK and US yield curves inverted.

Now, I realise this level of excitement makes a dinner with accountants sound wild, but an inverted yield curve, for all its geekiness, is something we should all be interested in.

Why? Because it is a signal of recession. According to Schroders – with only one exception over the past forty years – each time the yield curve has inverted, the US economy has entered a downturn within 18 months.

The yield curve explained

The yield curve is basically a line graph shows the difference between the interest rate on a longer-dated bond (debt issued by a company or a country) and a shorter-dated bond.

A ‘normal’ shape would be one where bonds with a longer time to maturity – say ten years – have a higher interest rate than those that are close to maturity (so the line goes upwards).

This is because it should cost less to borrow money over a short time period than over a long time period: investors in a bond due to mature very soon can be pretty certain they’ll get all their money back, whereas there is less certainty they will get it back in 10 years’ time. Therefore investors should expect a higher yield to compensate for that extra risk.

If the line is going in the opposite direction it means that it costs more to borrow money in the short term than in the long term. This is because investors are expecting the economy to slow and interest rates to fall, as central banks look keep the economy afloat rather than try to control inflation.

Schroders says that there is normally a lag of about one year from inversion to recession, so the yield curves are signalling problems for 2020.

What has caused this to happen?

Mark Holman, CEO at TwentyFour Asset Management agrees that an inverted yield curve is a very reliable indicator of impending recession. “We have been experiencing a globally coordinated economic slowdown,” he said. “It is true that economies in some parts of the world – such as the US and China – are still in reasonable shape, but they have been slowing down nevertheless.

“In the UK the economy is severely stuttering and has little room on the downside to avoid tipping into negative growth. In Europe, the largest three economies (Germany, France and Italy) have seen marked slowdowns and, like the UK, have little downside protection.

“This slowdown though is becoming quite protracted and the longer it has gone on, the more worried investors have become. The last few months of 2018 were, in our view, a brief dry run of what a recessionary environment might look like, and it was ugly.

“Soft landings have successfully been engineered in the past with a combination of monetary easing and fiscal expansion, and perhaps in the absence of extraordinary factors, the recent change of tone by global central banks towards easing might have been enough to encourage the cycle to continue.

“However, we do not have an absence of external factors, quite the contrary in fact. There is the seemingly ever more entrenched trade war between the US and China, which if not resolved could have some very severe consequences for both nations, their businesses and their consumers. And in the UK a hard Brexit would almost certainly tip both the UK and Europe into recession. So the inversion of the UK curve is only surprising in that it has taken so long.”

Could recession be avoided?

The multi-asset team at BMO Global Asset Management are slightly more optimistic and say that while a recession is inevitable at some point, the current market conditions do not suggest that this will be in the very near term and they think this period of expansion has further to go.

“On the one hand, the global economy is still growing, central banks continue to follow an accommodative monetary policy, inflation risks appear to be muted for now and employment statistics continue to show record numbers employed,” they said. “Company CEOs have also been very successful in reducing earnings expectations to such a level that there could be a significant number of positive surprises around earnings season.

“However, this does not paint the whole picture. The counter view to this rosy outlook is that while economies are still growing, they are doing so at a slowing rate. Although equity markets may be reflecting a positive outcome, bond markets are indicating almost the exact opposite. Yields this year have tumbled at a startling rate, suggesting in part that inflation expectations for the future have dropped even further, but also that the economy may be due a significant correction.

“Our view is that the bond markets are probably pricing in too pessimistic a scenario, as prices have overshot underlying economic fundamentals. We would expect yields to back up from here, but to remain fairly muted going forward.

“Expectations of rate cuts by the market are also, in our view, slightly overdone. Although it appears that a 0.25% cut will be delivered by the US Federal Reserve at the next meeting, expectations of a 0.5% cut look overly optimistic. With US inflation below 2%, there remains pressure, not least from President Trump, for more accommodative policy.”

One this is absolutely sure: an inverted yield curve is not good news. The only question is how bad this news is. Let’s hope the investment landscape doesn’t get too exciting from here!

The views of the author and any people interviewed are their own and do not constitute financial advice. However the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions. Before you make any investment decision make sure you’re comfortable and fully understand the risks. If you invest in fund or trust make sure you know what specific risks they’re exposed to. Past performance is not a reliable guide to future returns. Remember all investments can fall in value as well as rise, so you could make a loss.