What’s Causing Fear Around a Potential Recession?
Two stories have driven market fears recently. Let’s take a deeper dive into the potential effects of an escalating trade war and an inverted yield curve.
As the two biggest economies in the world, it is no surprise that the trade dispute between the United States and China is having a large effect on global markets. China is currently the largest consumer of primary energy and one of the biggest suppliers of labor and raw materials used in popular products from electronics to textiles. Tariffs are essentially a tax on these goods and services. The net effect of tariffs is often a decrease in economic profits and growth.
We don’t believe that either nation would like an escalation in the trade war if they can avoid it, especially heading into an election year. If a trade agreement is reached, we could see a sharp reversal of the negative impact of this uncertainty. If not, volatility will likely continue. For perspective, if you think of a tariff as a tax; everything announced or proposed so far amounts to far less than the value of the 2017 tax law changes.
What the Yield Curve Actually Means
The yield curve typically refers to the relationship between yields of different maturities on U.S. Treasuries. Economists at the University of Chicago noticed that a relationship exists between the shape of the yield curve and the probability of a recession in the next 12 months. The more inverted the curve, the higher the probability of a recession. Below is a brief description of what could cause this inversion from the author of the study, Campell Harvey.
“In a growing economy, the normal behavior of the yield curve is when longer-term rates have higher yields than shorter-term rates. There are many intuitive reasons why this is the case, but here’s the big one: one of the safest assets in the world is the 10-year government bond. When uncertainty increases, it is a classic safe-haven asset. Demand bids the price up and yields decrease. Indeed, many shift capital from short-term investments to longer term investments (like the 10-year Treasury bond) which leads to an inversion.”
During much of 2018, the Federal Reserve was also increasing short term rates, which drove up yields on short-term treasuries as yields were falling on longer-dated treasuries, accelerating the inversion. If the Federal Reserve were to reverse course and lower rates, the trend could potentially reverse.
What is not often publicized in financial media is that for this relationship to hold, the yield curve typically needs to be inverted for a full quarter. In addition, there is no guarantee that an inverted yield curve means there will be a recession. For reference, based on the Federal Reserve Bank of New York Study, “The Yield Curve as a Predictor of U.S. Recessions”, the current probability of a recession in the next 12 months is sitting around 30%.
There are many factors that can affect an economy, and speculating about a recession based on a single factor (the yield curve, for instance) is not a good long-term strategy for investing. Before the 2008 financial crisis, the Yield Curve inverted in July of 2006. The Return of the S&P 500 Index over the next 12+ months following initial Yield Curve Inversion was better than average, up over 25% (July 17, 2006 – October 31, 2007).