Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed-income and asset-mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.
The consensus among economy watchers for years has been that inverted yield curves signal recessions. It seems like every time the yield curve flattens – in other words, the spread in yields contracts between long-term bonds and short-term issues – wannabe gurus jump the gun and predict impending doom.
The inverted yield curve indicator, when these shorter-term yields eclipse the levels of longer ones, was not a consensus belief in the early 1980s. I discovered its value when a quirky economist visited my office in 1981. His work was considered unorthodox, but our management was intrigued by his prediction that the 1981-1982 downturn would be far more severe than expected. He based his work on the yield curve and other unorthodox indicators and predicted a shockingly strong recovery. He proved to be prescient.
After the 1990 recession and the dot-com crash of 2000, more market participants came to believe that yield curve inversions matter. In fact, in late 2006, there were warnings that we were headed toward rough times in a year or two. Even as recently as then, most of the investment professionals at my firm – especially in the equity division – scoffed at the idea. They and many others believed we had entered a golden age without recessions or significant bear markets, with annual double-digit returns being the norm.
I attempted to develop models to predict economic downturns that could be used to underweight equities and overweight bonds. I basically ran any data series I could get my hands on in an attempt to produce predictive models. I also looked at the work of other analysts and read academic papers in order to garner insight. Few indicators work all the time, and some leading indicators actually lag. Rigorous testing is better than trusting pundits.
One finding we noticed is that the yield curve indicator was much more accurate if two other conditions existed in credit markets simultaneously.
The first was yields well above inflation, at a time when markets expected interest rates to eventually fall. Right now, the federal funds rate, at 5.25 per cent, is only slightly higher than the consumer price index reading of 4.9 per cent. This indicates that short-term rates are not high. Of course, we should be aware that we have a banking system, corporate sector and private citizens so addicted to historically low rates that short rates may not have to rise much above inflation to create pain. Furthermore, current headline inflation is expected to fall. That would put it well below today’s short-term rate. Also, money supply as defined by M2 is falling, which is of concern.
But overall, this first condition has not been met.
The second condition is when corporate bond spreads relative to government bonds widen dramatically. This makes intuitive sense because fixed-income managers will sell credit positions if they fear economic stress will damage corporate balance sheets and cash flows.
Most years, corporate bonds produce greater returns over similar duration government bonds, as investors are compensated for credit risk. When the market expects economic problems, bond investors liquidate corporates, sending spreads skyward and prices down. For example, high-yield bond spreads as defined by the ICE BoA High Yield Index Spread soared from about 3 per cent in the summer of 2007 to almost 20 per cent in November of 2008. By 2011, that spread had returned to 5 per cent.
At this time, spreads are not indicating recession, and this second condition has not been met either. However, by the time spreads do blow up, it is usually too late for managers to sell their positions. This is because the corporate bond market is an institutional market and less liquid than government bonds, currencies and even large-cap stocks. Bond managers are subject to the same irrational panics as everyone else. They are compelled to overweight corporate issues in order to keep up with their competitors, beat the indexes and keep their jobs. When things get scary, they abandon ship quickly. Prices crash as there is pressure to sell corporates and buy government bonds, since long yields tend to fall in anticipation of interest rate cuts. Of course, this provides tremendous opportunity to buy corporates low and wait for reason to return. These blowouts have always proven to be tremendous buying opportunities.
Despite the two conditions I’ve outlined not being met, I think it’s still reasonable to believe that an inverted yield curve will be a precursor of a recession.
Not convinced? Consider that the “near-term forward spread” – the difference between the expected three-month interest rate 18 months from now minus the current three-month yield – is now deeply inverted. This particular spread is not on a lot of investors’ radar. But when in inversion, it has preceded every recession in the past 50 years.
In other words, it’s flashing red. Buckle up.
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