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The misinterpretation of the inverted yield curve

Sep 08, 2019

The inversion of the US Treasury yield curve made headlines last month. In Sonal Desai's opinion, the yield curve means nothing about the future of the world's economies.

There is a glaring contradiction in the fact that so many market participants and commentators emphasise the heightened level of economic uncertainty and, at the same time, seem to consider flat or inverted yield curves as fool-proof predictors of a recession. This is misguided – I don't think the yield curve tells anything about what lies ahead for the real economy.

A look at the evidence

Yes, protracted uncertainty on trade is having some impact on business sentiment. However, we have lived with trade uncertainty for almost three years now, with very little economic impact. The US economy is holding up well, and now it benefits from a more dovish US Federal Reserve (Fed).

China has shown a bit of weakness, but not a sharp slowdown, and the latest data shows that China’s lower exports to the US have been offset by stronger exports to the rest of the world. The weakness in Europe is more pronounced, notably in Germany as we’ve seen with recent gross domestic product data, but by no means a collapse.

The US economy continues to create jobs at a robust clip, even with the unemployment rate already at a 50-year low. According to the US Bureau of Economic Analysis, employee wages and salaries grew at 4.7% in 2017, 5% in 2018 and 5.1% in the first half of this year. Household consumption powers the economy, and the household saving rate as of June this year is at a very healthy 8.1%.

In short: the economic data shows no evidence that either the US nor the global economy is approaching a recession.

Feeding the fear

Government bond markets are still distorted by the major role that central banks continue to play. The Fed has cut interest rates and signalled the possibility of further reductions; the European Central Bank has opened the door to a resumption of quantitative easing. Major central banks are essentially inviting investors to ignore the economic data and bet on lower yields.

So, I think fixed income markets are betting on the Fed, and the Fed has just taken a dovish turn – ignoring the economic data. However, this betting on the Fed gives no indication whatsoever on where the economy is going. In other words, I think the Treasury yield curve has no value whatsoever as a predictor of recession. It’s just a good predictor of Fed dovishness, for now, and a sign of some panic in the markets.

The markets and the Fed seem to be looking at each other, feeding each other’s fears, and completely ignoring what’s actually going on in the real economy.

Sonal Desai, Ph.D. is the Chief Investment Officer at Franklin Templeton Fixed Income. This article is sole opinion of the author.

This article was originally published in The FM Report.