SINGAPORE (Feb 18): Should we panic over a Treasury yield curve inversion? Investors worked themselves into a tizzy in early December last year, sending stock prices tumbling around the world. That was when the Treasury yield spread fell sharply (see Chart 1), to the lowest levels since the global financial crisis.

For those unfamiliar with Treasury yield spread, it is the difference between shortand long-term bonds. The US Federal Reserve sets the short-term interest rate while investors determine rates/yields on the long-dated bonds via market prices. Yields on the long-dated bonds are typically higher than those for shorter-duration ones, owing to the additional term premium — to compensate for inflation over the duration.

Thus, when the difference in yields between the two- and 10-year bonds — the most popular market yardstick for Treasury yield spread — dropped to just 0.11% in late 2018, investor worries spiked. When this gap turns negative, we deem the yield curve as inverted.

The event made for sensational news headlines, triggering fear in markets around the world. Why is a potential yield inversion taken as such an ominous sign for stocks? Well, for one thing, the last five recessions in the US were preceded by an inversion of the yield curve.

In reality, the steepness of the yield curve offers little in terms of fresh insight into the underlying economy and more of changing investor expectations.

In December, investors’ views took a pessimistic turn on the US and global economy, and their actions — buying up long-dated bonds — caused yields to fall (bond prices and yields are inversely correlated). With long-dated yields falling while short-term yields remain high, this translates into a flattening of the yield curve. In extreme cases, the yield curve will invert. When that happens, it means investors expect a recession.

If the yield curve inversion and recession happen at the same time, which causes which? Bond yields — like stock prices — are reflective of investor expectations for the future. But, as we well know, expectations are as likely to happen as not.

That said, an inversion of the yield curve may have psychological effects that could be self-fulfilling, if it causes everyone to believe that a recession is imminent. Banks could start to tighten lending requirements — because of greater risks and lower profitability (smaller net interest margins) — thereby stifling credit, businesses would delay investments and hiring, and consumers could start to spend less, all of which will result in slower economic growth.

Is the yield curve inversion a signal to sell stocks?

Even if yield curve inversion does precede recession, it can neither predict the timing, length nor depth of the recession — and, crucially, how stock markets react. Historically, inversions have happened between six months and two years before a recession — during which stocks have traded flattish, up and down (see Charts 2a and 2b).

All this just means that trying to predict stock market movements is a fool’s errand. Narratives, it seems, do not move stock prices. Rather, reasons are provided for stock movements, after the fact. As value investors, we would be much better off looking at the underlying business, earnings, cash flows and balance sheets instead of trying to time the market.

Is a recession imminent?

Economic cycles of expansions and recessions are as inevitable as death and taxes. But I do not think there is any fundamental reason for economic expansion to die from old age.

In theory, economic growth gets derailed when rising demand for goods, capital and labour causes inflation, which then results in central banks’ (over-)tightening monetary policy that will lead to a slowdown or, worse, recession.

However, this traditional relationship between output, employment and inflation appears to have broken down. Case in point: The US recovery is heading into its 10th year and unemployment is at 50-year lows. Yet, inflation remains benign, barely above the Fed’s 2% target.

Real interest rates remain low by historical standards. This is due, in large part, to technology advancements and digitalisation, which have been very effective in capping inflationary pressures.

We have seen how technology and digitalisation greatly enhance operational efficiency, improve the price discovery process, raise assets utilisation and productivity and so on.

Technology underpinned the rise of the oil shale industry and brought oil prices down from record levels. Continued advancements in green energy technology are likely to keep future prices lower. Low oil prices, in turn, play a huge role in tempering costs and price inflation.

The Treasury yield spread has widened a little since the lows in December, currently hovering around 0.18% — as the worst of investor panic subsided. It may or may not fall into negative territory in the coming weeks or months as investors continually recalibrate their expectations for the future. Regardless, I suspect the yield curve will be flatter than we are used to seeing in the past, even after the Fed normalises monetary policy, owing to low inflationary expectations.

Also, in reality, most recessions are triggered by exogenous events — such as geopolitics, war, trade conflicts and asset bubbles — that are inherently unpredictable.

Stocks in my Global Portfolio ended mostly higher for the week. The total portfolio value gained 5.2%. China-based companies such as Sunpower Group, Nine Dragons Paper (Holdings) and Ausnutria Dairy performed well after the long Chinese New Year break.

Investor sentiment for equities stayed positive amid rising expectations of a US-China trade deal, while a more dovish Fed is aiding the recovery in emerging-market currencies.

Last week’s gains pared total portfolio losses to just 4.1% since inception. By comparison, the MSCI World Net Return Index is down a lesser 0.4% over the same period. 

Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore


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