Fixed Income

The rally in 10-year bond yields over the past six months has seen the spread differential between 10-year and 3-month bond yields fall to -30 basis points. Historically, this level of inversion is a signal of recession, which only occurred in 1989, 2000 and 2007 as shown in Chart 1.

Chart 1 US 3-month and 10-year curve

Source: Bloomberg

What this bond market signal is telling us is that the market is beginning to signal that a full-scale rate cut cycle is potentially coming from the Federal Reserve (Fed). To explain this we can use some simple arithmetic and history.

Starting with Chart 1, we can see that the average spread between 10-year and 3-month bonds since 1985 is around +1.75%. Historically speaking, Chart 2 shows that once we reach this level of curve inversion (grey bars), the curve steepens via the 3-month rate falling drastically lower (shown as the blue line (3m) dropping away, rather than the green line (10Y) rising.

Chart 2 Bond yields and 3m/10y inversion

Source: Bloomberg

This poses the question of how far would cash rates need to fall to normalise the 3m/10Yr curve to the average level identified above? Since 10-year bonds are currently trading at around 1.70%, this implies that the 3-month rate needs to fall to 0% to give an historically average level curve. In other words, the bond market is telling us that it’s not out of the question to expect the cash rate to fall back to zero from here.

And this leaves us with the next question: What would cause the Fed to cut 200 points?

A recession certainly jumps to mind, meaning bond yields are telling us that recession probabilities are likely higher than the market currently perceives.

Major exporters feeling the pain

One of the most important charts that we are watching at the moment is the consistent slow-down that is occurring across Global Manufacturing PMI’s. We take the average PMI level of the world’s five largest exporters — US, China, Germany, South Korea and Japan — and see that the average PMI level of the world’s largest exports is now contractionary.

When we combine the slowdown of this indicator (late 2018) with the timing of the curve inversion, we arrive at the conclusion that the slow-down in global trade is having a larger effect on economic growth than previously expected. Hence investors should be watching PMI figures for either improvement or deterioration, as it will give a timely signal of how global trade is fairing.

Chart 3 PMI of the five key exporters

Source: Markit

Outlook

Our current outlook is the most variable that we have seen in a number of years as two potentially polarised ranges are appearing. Given the US yield curve is so inverted there is a relatively high risk of recession over the next twelve months, which means we can group our expected outcomes into two buckets:

  1. A recession occurs – Rates rally as the Reserve Bank of Australia (RBA) continues to cut rates (or look at Quantitative Easing) and this will pull bond yields lower.
  2. Growth is fine – Interest rates stall or sell off as the RBA is able to take a break, similar to what occurred in 2013 or 2016.

Hence we need to understand where the recession probability truly sits before we are able to make a large interest rate call. If recession odds are 50-50, then the view can be thought of only as uncertain going forward. The optimist will want to state that everything will be fine and bond yields should sell off, but the signal coming from the interest rate curve should cause some reflection.

Important Information

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