Should We Be Concerned About The Yield Curve?
On the latest edition of Market Week in Review, Senior Quantitative Investment Strategy Analyst Kara Ng and Sam Templeton, manager, global communications, discuss why we should pay attention to the US yield curve, President Trump’s tariff talk, and the latest corporate earnings reports.
US yield curve getting close to inverting
The slope of the US yield curve has fallen to just 24 basis points and getting close to inverting. Ng says “we should pay attention because an inverted yield curve is historically one of the best predictors of a downturn.” She notes over the last 5 economic cycles, an initial inversion preceded an economic recession between 9 and 18 months, while equity markets tend to peak about 6 months before a recession. This means there’s a large negative impact in being defensive in your portfolio too late, but also a cost in being defensive too early, and missing out on the late-cycle gains. Ng says savvy and timely investment strategy is everything. And while the slope of the yield isn’t inverted yet, it has uncomfortably flattened. She is currently expecting a recession in late-2019 or 2020, so believes it’s still too early to go completely defensive.
Should the Federal Reserve be more concerned about the yield curve?
Federal Reserve Chair Jerome Powell testified before the Senate Banking Committee in Washington this week and didn’t express a lot of concern about the flattening yield curve. Ng says Powell was upbeat about the economy and affirmed that gradual rate hikes are appropriate; for now it’s the neutral rate he’s more focused on than the shape of the yield curve. The neutral rate isn’t something you can observe, but is the theoretical rate where interest rates neither hurt nor help the economy. Ng is concerned that the Fed hasn’t paid enough attention to the slope of the yield curve historically and has argued “this time is different” too often. She explained it contains lots of information. For example, when the 10-year rate falls lower than the current short-term rate, it may be that the market expects lower short-term rates in the future, possibly because of a future growth slowdown resulting in the Fed cutting rates to stimulate the economy. Meanwhile, she says the shorter end of the curve is heavily influenced by the current Fed policy. If the Fed raises interest rates too far above sustainable fundamentals, then the restrictive monetary policy might start a recession. Ng says not to ignore the yield curve.
Trump threatens more tariffs on China
Ng says a month ago it looked like a US trade war with China was a risk, but not our central scenario. Now, she says the odds of a full-blown trade war are closer to 50/50. Ng says the tariff announcements are probably a “maximum pressure” negotiation strategy, because the US wouldn’t benefit from closed trade. She notes a lot of the tariff goods are intermediate, not final goods. That means that those goods are an input to some final product that could be made in the US. In the short run, US companies would have trouble finding substitutes for those intermediate parts, which would hurt US businesses. Ng says to keep an eye on how consumer and CEO confidence develops given potential disruptions to global supply chains.
It’s still early days in the reporting season, but so far Ng says the Q2 earnings season is surprisingly strong. Only 17% of US companies have reported so far, so Ng isn’t extrapolating too much from the small sample size, but of those companies, about 95% have beat expectations. She says that’s high, especially since earnings expectations were optimistic to begin with. However, market response has been relatively muted. Ng expects the Q2 earnings season will be strong, but not as strong as the Q1 season. Some of the macro tailwinds that previously helped Q1 earnings are fading – global growth is moderating and the US dollar strengthened, which impacts US multinational companies’ earnings.
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