Year of the Dog reflections: Treasury curve tribulations

At the beginning of every Chinese New Year, AsianInvestor makes 10 predictions about economic, political and financial developments that are likely to have an impact on the way institutional investors assign their money. One year later, we revisit these forecasts to see how well we did.

Our third Year of the Dog forecast was to look at whether an increasingly inflationary environment and concerns over the long-term prospects of the US economy would cause its Treasury bond yield curve to invert.  

Will the US Treasury yield curve invert?

Answer: No – incorrect

In early 2018 investors and economists were increasingly turning the thoughts to the outlook for the US economy.

To be sure, the immediate signs looked good. In December the previous year, the Republican-controlled Congress had ushered through the largest combination of corporate and personal tax cuts in decades. 

Economists predicted – accurately – that these would bolster corporate balance sheets throughout the year and help turbo-charge GDP growth.

Indeed, the main fear was whether this was too much of a good thing. The US economy has been on growing for a decade and another recession looked overdue, at least compared with previous cycles.

With unemployment levels low and the stock market riding high in early 2018, economists and investors wondered whether the catalyst for the next downturn could be rising inflation, and the tax cuts made this look more likely.

Accelerating inflation meant the US Federal Reserve was likelier to raise interest rates more aggressively, so the argument went, thereby increasing the risk of policy overkill.

In an environment where short-term interest rates are rising and investors become more concerned about the economic outlook for the next year or three but at the same time more sanguine about the longer-term outlook because they can imagine policy being eased again and the economy recovering – that's when a country's yield curve can invert. In this case, yields on shorter-dated US government bonds rise above those on longer-dated ones.

Historically, such a phenomenon is a reliable portent of an incoming recession, which often arrives six to nine months after the curve's inversion.

However, we did not think the US economy was becoming so overheated it would cause an inversion. 

So what happened? Well, the Fed did indeed raise US interest rates during 2018, increasing its benchmark rate four times by 25 basis points each time to end the year at 2.5%.

US president Donald Trump fulminated against the last rate increase on December 19, concerned that it would stymie his predictions of up-to-4% GDP growth going forward.

Nevertheless, the US economy still enjoyed a healthy 3% growth during 2018. And despite the unease among economists and the sharp stock-market correction seen from October, the US yield curve stayed positively inclined for almost the entire year, although it did become progressively flatter.

But our prediction, ultimately, was proven wrong on December 3, when the three- and five-year portions of the Treasury curve did technically invert, with the yield on the three-year Treasury at 2.84% and the five-year Treasury quoted at 2.83%. The next day the five-year yield also slipped 0.1% percentage point below the two-year yield.

Still, the period of inversion was relatively brief, lasting just 10 days. As of January 23, the three-year Treasury had a yield of 2.57% while the five-year stood at 2.59%. And it's worth noting that the most keenly observed metric of inversion, the difference between the two- and 10-year yields, always remained positive, even if it often follows inverted five- and two-year yields into negative territory. 

So we can count ourselves very unlucky.

Does this relatively small inversion presage an inbound recession for the US economy? Opinions vary. AsianInvestor will offer our view about the likelihood of an economic downturn in the world’s largest economy in our coming Year of the Pig predictions. Stay tuned.  

Previous Year of the Dog reflections:

Will Donald Trump be the US president at the end of 2018?

What will be the best performing mainstream asset class, on a risk-adjusted basis?