I am surprised by the recent commentary on rates

In today’s environment, reading too much into the yield curve is bound to deliver all sorts of false positives

Aug 9, 2019 | Krishna Memani

You can count me as surprised.

But not for why you are thinking – that the ticker tape is not looking very good now or that safe assets are rallying.

When the two largest economies of the world are firing warning shots across each other’s bows, that the stock market is reacting ought not to be a surprise

What I am surprised by is the number of conclusions being drawn about the interest rates markets on a global basis.

You can’t go to any financial publication without reading about the blaring signals of an imminent recession that the bond markets forecasted.

The level of interest rates, the steepness of the yield curve—everything seems to be pointing towards an imminent recession. And thus, the end of the bull market.

But if you look a little deeper, it becomes quite clear that at the end of the day, this, is the ultimate form of confirmation bias.

Some investors and commentators who are convinced that a recession is imminent are simply going to certain parts of the bond market and looking for data to confirm their views.

To be sure, the level of yields and shape of the curve, at various points over the past few decades, have predicted recessions, or, at the very least, foretold the rising probabilities of them.

But we are in a different inflation and interest rate regime since the financial crisis. Interest rates on a global basis are being driven as much by structural disinflationary issues — or deflationary if you want to be dramatic — around the developed world including liability immunization, cross-border flows, and policy actions by various central banks who are carrying out their own political mandates and pressures.

In other words, the US Treasury curve may not be as reliable an indicator of the potential growth rate of the U.S. economy as it has been in other inflationary regimes. If you accept that premise, then reading too much into the yield curve – whether its shape or the level of yields –is an exercise fraught with the risk of delivering false positives.

You just have to look at the 10-year Treasury yield (TSY) chart over the past ten years to see the risks.

Figure 1: US 10-Year Bond Yield

Source: Bloomberg LP, 8/7/2019

We have been here before without any material disaster.

However, there is another part of the bond market that is far more vulnerable to economic activity and less impacted by global flows and disinflationary pressure than safe assets are – and that is the credit market.

If things are headed south for the economy in a big way, credit investors would be hurt and hurt badly. So, credit investors’ views about the prospects of the global economy should contain as much, if not more, information than the actions of investors in the government bond market do.

And if you look at the spreads of the US investment grade market—the deepest credit market in the world—you find a very different story than the one US government bonds are telling.

Figure 2: Investment Grade Credit Spreads

Represented by the Bloomberg Barclays Aggregate Credit Index Option Adjusted Spread (OAS)*

Source: Bloomberg LP, 8/7/2019

Yes, risks have increased as trade concerns have flared up and spreads have certainly widened. But where is the panic?

The closest we came to a recession in this cycle was when the frackers blew up in 2015 and 2016 or when the credit markets reacted poorly to the Eurozone nearly breaking up in 2011. 

Nothing even close to that is happening in the credit markets…YET.

Still, I am not dismissing the fact that the price action in the market is concerning. Nor am I asserting that the drivers of the market at the moment — like trade – do not have the potential to propel us into a recession Far from it. If things continue to go down the path of currency wars – that is, the situation becomes far worse than just trade tariffs – we could get to a recession quickly.

Instead, my point is that you should look at the balance of evidence from all macro markets – including rates, credit and currencies – to come up with your prognostication for the global economy. Yes, it is true that government bond markets are signaling potential issues, but that is not being corroborated by the credit or currency markets.

Krishna Memani serves as the Vice Chairman of Investments for Invesco.

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