Commentary by Andrew Patterson, senior economist in Vanguard Investment Strategy Group
Concerns about a U.S. recession have increased in the last few months because of bond yields. The U.S. Treasury yield curve inverted briefly in March—yields of shorter-term bonds were higher than those of longer-term bonds—and has inverted again in recent days.
A yield curve inversion is contrary to the normal order of things, and market participants often see them as a predictor of recessions. A yield curve inversion generally lasting more than a month has preceded every one of the seven U.S. recessions in the last 50 years.
We asked Vanguard Senior Economist Andrew Patterson for his take on the inversion and what it could mean for the markets.
Short-term rates have been pretty steady this year, so the yield curve inversion has been due more to longer-term rates falling. How far have they come down in 2019?
Yes, the inversion is due more to longer rates falling, and that is typically how yield inversions come about. If you think about it, the [U.S.] Federal Reserve wouldn't have any reason to raise short-term rates higher than longer-term rates intentionally. In the normal order of things, investors are rewarded with higher interest rates for tying up their investments for a longer period. The markets haven't moved the 3-month Treasury bill much in the first five months of 2019, whereas the yield on the 10-year Treasury note has sunk by roughly half a percentage point, which we would attribute largely to a general risk-off sentiment that has come over the markets in the last month and a half. As of May 31, the 3-month Treasury bill was yielding 21 basis points more than the 10-year Treasury note.
Yield curve inversions have preceded recessions
Note: Data are from January 2, 1968, through May 31, 2019. Sources: Vanguard, Moody's Data Buffet, and Federal Reserve Bank of St. Louis.
How likely is a U.S. recession?
We see about a 30% chance of a recession in 2019, but we're constantly revisiting that figure as economic conditions and risks evolve.
I should note that our assessment was made before the most recent escalation in trade tensions with Mexico and China, which has hurt market sentiment and which we'll need to watch in coming months for any actual harm to the economy.
The recent yield curve inversions haven't really had much of an impact on our thinking about a recession this year. An inversion signals what you might expect to see maybe 12 to 18 months down the road. That said, the deeper this inversion goes and/or the longer it lasts, the higher the probability of recession, so it's something we will continue to monitor.
How likely are we to see a return to an upward-sloping yield curve (where longer-term bond yields are higher than shorter-term bond yields), and what would need to happen for that to occur?
Short-term yields are largely determined by central bank policy. Since we aren't expecting the Federal Reserve to adjust rates at all this year, there isn't likely to be much movement at that end of the curve. So longer-term yields would have to rise to produce that upward slope. For that to happen, we would have to see stronger fundamentals, and stronger inflation in particular, as our research shows that it is a key driver of longer-term yields, including that of the 10-year Treasury note. That's what happened back in March when the yield curve switched back to being upward-sloping.
What about major bond markets outside the U.S.?
Yields are low across developed markets, and still negative for some maturities in many European countries and Japan. It might be worth noting that those low yields are actually putting downward pressure on longer-term Treasuries in the U.S. As odd as it may sound, even with an inverted curve, foreign bond investors in their reach for yield are still seeing value in the 2%-plus yield on longer-dated U.S. Treasuries.
Vanguard is well known for advocating a long-term approach to investing, typically suggesting that investors with carefully constructed portfolios ignore market noise and any temptation to make tactical moves. Any suggestions as to what they should do?
As we were expecting in our 2019 outlook, we may see a slowdown in growth, and the yield curve inversion is another factor supporting that view. The inversion, though, is not a timing signal or a call to change your portfolio. Tactical bets are always very difficult to execute successfully. Instead of adjusting your portfolio because of an expected slowdown or even recession, it makes more sense to prepare yourself mentally and cultivate the resolve not to react. This would also hold true if one were expecting stronger growth. Making asset allocation changes based on growth expectations tends to be counterproductive. Unless your financial goals change in terms of your circumstances or your time horizon, your portfolio shouldn't change just because a slowdown may be on the horizon.
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