The Motley Fool

Will There Be a Recession Soon?

Recently, market commentators have picked up on the flattening yield curve from the US bond markets as a sign of impending recession. As of end June 2018, the spread between 2-year and 10-year US Treasury Bonds stood at 33 basis points (one basis point is equal to 0.01%).

Interestingly, the flattening yield curve was the subject of interest in a research paper published by the Federal Reserve Bank of San Francisco back in March 2018. The paper noted that every US recession in the past 60 years was preceded by a negative term spread or an inverted yield curve.

Why is the yield curve flattening? From a simple perspective, short-term interest rates have risen faster than long-term interest rates. The Federal Reserve hiked interest rates by 25 basis points in June and signalled for two more rate hikes in 2018, one more than previously forecast. US inflation hovers near the Fed’s target rate of 2%, and US unemployment rate is an 18-year low. US companies also turned in a record earnings season earlier this year on the back of low-interest rates and continued US economic growth.

Why then have long-term interest rates failed to keep pace? A simple answer would be that investors continue to hold a pessimistic long-term economic outlook and expect low inflation and output growth to persist. That answer runs contrary to the current economic strength in both the US and Chinese economies. Quantitative easing continues to persist in major developed countries. The 10-year German bund is priced at a paltry 30 basis points whereas the Japanese 10-year government bond barely pays a 10 basis points coupon. There are only so many investments with a similar credit profile to the US Government Treasuries, and that explains why the long-term yield curve has been held constant.

Using a single metric to predict an impending recession surely is a case of the tail wagging the dog. Unlike 2008, major financial institutions today have tried to shore up their capital at risk and are not holding massive positions in asset-backed securities vulnerable to property market bubbles. Today, the headwinds to continued growth would be the US’s increasingly robust stance in trade relations with other major economies. While we should expect short-term uncertainty to persist as global trade relations re-balance, it is unlikely for countries to revert to the days before today’s globalised economy. Many products continue to be designed in the US, manufactured in the emerging markets and re-distributed to the rest of the world. Free and fair trade make both dollars and sense.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.