In this week’s economic update, we begin by analysing factors around the recent US’ yield curve inversion. Following this, we breakdown the latest sentiment and fundamental economic data emanating from the US, to ascertain the impact on consumers and the economy as a whole.
Inverted Yield Curve – What’s all the fuss about?
On the 22nd of March, the US yield curve, a leading indicator closely monitored by investors, inverted. You may wonder, rightly, what this means and why the yield curve creates a fuss when it changes shape. Moreover, why the major fuss when it inverts, which is also sometimes referred to as a negative yield curve.
First, we need to briefly explain the yield curve. Basically, governments issuing bonds stagger their repayment dates. This helps smooth out the pattern of borrowing. To do this they offer bonds with a range of maturities, usually stretching out up to 30 years.
Investors buying bonds today from the US or UK governments are fairly certain they will get their money back, but, over time, they worry about a different risk- inflation. At the point of purchasing bonds, they do not know what inflation will be over the next 5, 10 or 30 years. Thus, for longer dated issues they usually demand a higher yield. This compensates them for accepting the risk posed by inflation which directly impacts the real return they expect.
By demanding additional compensation for longer dated maturities, investors should expect to see a yield curve sloping up with time. The chart below, purely hypothetical, shows what the curve should look like under these conditions i.e. lower rates at the short end, growing steadily higher over time and thus upward sloping.
Hypothetical ’Normal’ Yield Curve
Source: TPI, March 2019
Of course, the economy constantly changes and yield curves can stray from their ‘normal’ shape. At times they may be flat, steep and, as discussed, even inverted right along the curve or in parts of the curve. The deduction from yield curve flattening is that economic activity is being forecast to slow, which of course is happening in some areas of the economy now. When the yield curve inverts market commentators begin to worry about recession risk.
However, as we explain later this isn’t at all straightforward. In our view, the signal sent out by bond investors needs to be interpreted carefully.
Today, the yield curve has an odd shape. It is inverted in the middle section of the curve- see below.
When you look at the chart carefully you can see it is quite flat for the first 6 months of maturities but yields for maturities of longer than 6 months, and out to 10 years, start to trend lower. Further out, yields rise again, this time shifting higher than yields on offer at the short-end.
The dip in the middle is where the curve is ‘inverted’ i.e. negative. Bond investors calculate this by subtracting the yield at the short-end from yields with a longer period. When the difference between the two periods is negative, the curve is inverted e.g. subtracting the yield on a 1-year bond today from a 10-year bond, the spread or difference is -0.2%
Current US Treasury Yield Curve
Source: Bloomberg, March 2019
Many commentators are already concluding that the appearance of negative spreads is bad news. However, as we said earlier, it is important to interpret the results carefully, so we decided to dig a little deeper.
Below we show the yield curve now compared to the shape of the curve back in 2007. This is when the yield curve last inverted, and recession followed. For many this occurrence is what gives credence to the notion that an inverted yield curve is a reliable warning indicator.
Current US Treasury Yield Curve vs Pre-Financial Crisis Yield Curve
Source: Bloomberg, March 2019
Although there are some similarities in the shape we can point to some very important differences.
First, check out the left-hand scale v the right-hand scale. Interest rate levels in the comparative period 10 years ago are twice as high as they are today. The second aspect to note is that inversion in 2007 happened right along the curve, as far as the eye can see, out to 30 years. This suggests broad inversion may be needed to forecast a marked reversal in the market cycle, something we currently do not have.
Conclusions we have drawn:
When you read headlines warning of an inverted yield curve showing up now in parts of the US bond market we would ask you to keep in mind the following explanations:
US interest rates today remain very low. Recessions normally occur when interest rates or inflation levels spike upwards, sharply. Yes, rates have been pushed up 8 times since December 2015, but the US Federal Reserve have signalled a halt to any further rises. They have indicated they are no longer intent on raising rates this year, and inflation is falling.
The yield curve is thought to be distorted by Quantitative Easing (QE) policies. This involved governments buying huge amounts of bonds, thereby depressing yields. This unconventional aspect of monetary policy hasn’t featured in any prior economic cycles.
In the private sector, pension funds worried about sizeable pension deficits, have been de-risking their investment portfolios. This has pushed these ultra-cautious investors into buying longer dated bonds, regardless of low yields on offer; again, their actions push yields down even lower along the yield curve causing distortions.
The US has had 5 recessions in 40 years. This is a small sample to judge whether one measure, the spread between short and long dated bonds, is a cast iron way of signalling recession.
Confidence, Consumers & Cash
Last week we focused on jobs and wages trends underway across the UK and Europe. This week we steer towards the US, focusing on recent sentiment-based data. This is what is also referred to as soft data or forward-looking data. We then look at how sentiment data feeds into fundamental data often referred to as hard or backward-looking data.
One of the leading indicators used by economists in the US is the Michigan Consumer Sentiment Index, or Michigan CSI. This measures the average confidence level of typical consumers. It is an insightful index which can act as a barometer for future spending. Later, we look at the signal from the CSI and how it leads hard data on retail sales. In other words, we can use the index as a gauge for future spending trends.
What we do know is that consumers who feel confident about the economy are also usually more optimistic about their employment prospects. Therefore, they typically have an increased willingness to buy larger scale asset purchases such as houses but also spend more on smaller discretionary and non-discretionary items such as holidays, food and clothing. These items are captured through retail sales data indices.
To begin, we examine the way sentiment can shift. For example, after December’s sell-off in equity markets, we can see how the CSI index dropped quite dramatically. Presumably, consumers felt less well-off and, affected by market uncertainty, their confidence dipped. When equity markets recovered the CSI index rebounded strongly in February, with a continued resurgence in March.
University of Michigan Consumer Sentiment Index
Source: Bloomberg, March 2019
If these shifts take place in the short-term then what about longer-term trends? In the chart below, we review the behaviour of the CSI index over the last 10 years. This demonstrates a very strong recovery in confidence levels since the financial crash.
University of Michigan Sentiment Index 3 Month Moving Average
Source: Bloomberg, March 2019
With confidence levels high we can see this reflected in higher retail spending in the following chart. Here annual sales are trending strongly positive, peaking at 9% in December 2018. The dip in confidence after December translated into lower levels of spending but with confidence recovering again we expect to see retail sales starting to push higher.
Redbook Retail Sales Growth
Source: Bloomberg, March 2019
This shifting pattern of confidence and retail sales is what brings us back to wages. While rising stock markets make people feel wealthier, higher wages, as pointed out last week, lift disposable incomes. This is what increases the propensity to spend.
We leave you with a chart which shows that wages are rising nicely in the US, not just in nominal terms, but more importantly in real terms after taking account of inflation which should continue to bolster consumer confidence.
US Wage Growth Vs Inflation
Source: Bloomberg, March 2019
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