US recession risk grows as yield curve inverts

Amid market exuberance following the trade-war truce, a sober warning sign has emerged. Photo / 123RF

Is the US on the brink of recession?

Well, if you believe the theory that bond markets rule the world, then maybe.

As market exuberance around Trump's trade war truce faded, a sober warning sign has emerged that all is not well in the US economy.

US bond markets spoiled the equities party on Wall Street this week as the treasury yield curve inverted – something widely considered an accurate predictor of recession.

The yield on the Five-year US Treasury note fell below the yield on the Three-year note.

That means bond investors get paid more to hold shorter-term US government debt than they do for holding it for a longer term.

If you think about the interest banks offer on their term deposits - that's not the way it is supposed to work.

When the inversion happens it is considered a sign of pessimism about the long-term outlook.

This was the first time it has happened in the US for more than a decade.

"That's huge," screamed the headline on financial news site Bloomberg.

According to US Federal Reserve research, an inverted yield curve preceded all nine US recessions since 1955, with a lag time ranging from six months to two years.

Thankfully it has not yet inverted between the two-year and 10-year notes.

That's considered the real harbinger of doom and happened before the recessions of 1981, 1991, 2000 and 2008.

But Mark Brooks, head of income at NZ Funds, warns its a bit early to get worked up about an economic meltdown just yet.

Even when you looked at an inverted curve on 10 and two-year notes, there was often still a long lag before it hit the real economy.

"That curve went negative in December 2005, two years before the big meltdown," he said. "Likewise in 1998, it went negative in June 98, a year and half to two years before the market problems."

But this trend was important.

"Clearly its telling us something," he said. "What is telling us is that business cycle is peaking and it's part of that process."

With the US Federal Reserve having hiked rates eight times and still heading to a neutral stance this was the kind of pattern you had to expect, he said.

"Certainly credit markets are struggling in the US and they tend to be slightly more forward looking than equities."

But there was still plenty of other strong economic indicators coming out of the US including job growth and manufacturing data, he said.

"So there are indicators that we're getting to the end of the cycle but we don't think there is any flashing red lights at this point."

What we were seeing in the US was a reassessment of growth and inflation, Brooks said.

An that was probably a healthy thing.

"Arguably people are weighing up risk and reward again, rather than just looking for reward," he said. "That is a much more balanced process and one that may extend the later part of the cycle."

Meanwhile New Zealand's yield curve for Government bonds remains in firmly in "normal" territory - with higher yields for longer terms.

Brooks said he was not necessarily expecting our interest rate curve would follow the US.

"Even the 10-year part of the curve that is usually quite correlated, has been moving to its own beat," he said.