iFund-Why should we care about inverted yield curve?

2019-03-25 08:31
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The world’s biggest bond market is calling for an economic downturn in US future. When this is the first time the curve has been inverted since 2007, during the last cycle, the spread first fell to below zero in January 2006, almost two year before the start of recession. If history repeats, that means economy will be slump for late 2020 or early 2021.

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The spread between yields on Treasury bills and the 10-year note, a closely watched signal for the health of the economy, inverted for the first time since 2007 on Friday after US PMI manufacturing data missed estimates. What is there to say about the inverted yield curve?

Inverted yield curve is a reminder that cycles end

The world’s biggest bond market is calling for an economic downturn in US future. When this is the first time the curve has been inverted since 2007, during the last cycle, the spread first fell to below zero in January 2006, almost two year before the start of recession. If history repeats, that means economy will be slump for late 2020 or early 2021.

However, it seems to a lot of time for risk asset to outperform or the economic outlook to improve. What’s more, the median projection of policy makers dropped to zero, compared to additional 4 times after first inversion in 2006. The Fed decision last week to call an end to interest rate increases suddenly can also stop economy hard landing.

Beware Misreading Inverting Yield Curve

Yield curve inversions are unusual because money lenders are willing to earn less interest income for longer. This typically happens when investors expect yields on shorter-term will fall because of Fed rate cut, and dragging down on long-term bonds. It is more likely that economy is slowing sharply and faces a recession risk.

But the pessimism about growth ignores the fact that strong labour market will continues to support consumption. It is true that government shutdown and trade war hurt economy sentiment in Q1 this year. But it is too early to draw a conclusion that US face a recession. Government investment, modest inflation, dovish Fed and tight corporate bond spread will support US economy.

Can Emerging Market benefit from that yield curve?

Inverted yield curve can be no big deal or even good news for Emerging Markets. It is a strong sign that Fed policy is too tight. It is no surprise that Emerging market favour that yield curve.

But the most important question why emerging market bonds have rallied so fast this year. The dovish Fed can be one important reason. But China policy has been another major catalyst. At the beginning of 2019, China central bank cut RRR ratio. Traders now bet that China is opening its liquidity taps again.

The question of the Emerging market future is credit cycle in China. The first month of total social finance is big enough, but Lunar New Year distort the first two months data. At this point, everyone is waiting for March data released in April. The data will show investors direction.

Last but not the least, investment sentiment is also important. The more people misread the yield-curve inversion as a signal of looming recession, the more stocks are likely to fall and volatility to rise, and the greater the risk of pockets of market illiquidity. All of these, if sustained, could dampen household and business confidence, postpone business investment decisions, and pull the rug out from under growth.

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