Inversion of yield curve, a possible recession?

Investors were literally on the edge of their seats, glued to television sets when the 2-year and 5-year yield curve inverted in December after Fed raised the rates to 2.25%-2.5%. It was prominent that market hadn’t expected another hike in December which was evidenced by the worst single month decline in S&P in years.

However, strong economic numbers, low unemployment and better than expected third quarter earnings managed to pull market into the green territory. Not only Fed, in its dovish tone, tried to pacify investors reciting low possibility of a hike this year, positive updates on the seemingly never-ending trade war with China has also kept investors bullish. Certainly, it seemed like market was off to its best year in a decade. Nevertheless, celebrations couldn’t last longer. While the fear of recession nagged investors since late last year, roaring market has been able to disguise it somehow. But, the recent inversion of three-month and ten-year curve brought back the fear of a looming recession and made investors jittered.

A lot has already been said about the inversion of yield curve and its ability to foresee a possible recession. Although, it’s intuitive that people are not very optimistic about the future economy which led to lower long-term yields, it’s important that people know why long-term yields should ideally be higher than short-term yields. Moreover, I am going to touch upon few macroeconomic indicators that may hinder future growth.

Yield on a US treasury is the interest that you’ll get on govt debt obligations. Lenders expect higher yield on long term treasuries in order to be compensated for inflation and the risk of default. Since, treasuries are backed by the creditworthiness of US govt, inflation is the major reason for higher yields.

Slowdown in the month of December has left people wondering about the future course of economy and with the inversion of 3-month and 10-year yield curve, future does look bleak. Trade war with China, uncertainty over Brexit, Italian debt crises, slowing growth in Germany, central bank’s feud with government in south east Asia and upcoming elections, exacerbate the concerns and sent investors scurrying for the apparent safety of US treasuries, pushing long term yields down. Yield on German bonds has already gone into the negative territory.

Global political vagueness and fear of recession are likely the reasons behind the long-term pessimistic view on the economy. However, it is possible that economy is retracing back to its equilibrium which has been displaced by Trump’s overly protectionism (mercantilism) and tax cut stimulus.

• Prolonged trade war and continuous tariffs on imports can increase the cost of raw materials resulting in reduced margins.
• Since inflation is at the bay, efforts to shift the demand curve right through monetary and fiscal policy won’t necessarily have the desired multiplier effect.
• Negative market sentiment can have a domino effect leading to sharp reduction in consumer spending causing aggregate demand curve to slide down.
• Even if Trump’s trade war ends and US manages to sail through all the impediments, there still prevails high uncertainty with China’s slow growth, Brexit and Italy’s debt crises which could result a global slowdown. 
• It will become harder for Fed to revive the economy in case inflation keeps going down. Europe has suffered from negative interest rates for years.

Believe it or not, Trump has been providing stimulus to the economy for past two years. Tax cut in 2017 has benefited companies in a massive way.

While as bizarre as it sounds, trade war with China did have a positive impact on domestic American companies in short term with increase in business and consequently, leading to higher margins.

However, putting tariffs on Chinese goods does good only for a short period of time as decrease in globalization would put upward pressure on inflation due to less competition from foreign firms. Economy has finally started to return to its equilibrium with diminishing effects of further stimulus. Any increase in capital supply would likely increase the marginal propensity to save. With the reduced consumer spending (assuming higher sticky price and wages), companies may start to lose business and execute layoffs.

With Brexit showing no signs of concluding, slowing growth in china and upcoming election in India, geopolitical uncertainty is going to enshroud global markets in 2019. But amid all that, market sentiment will play a decisive hand in 2019.

While it’s hard to predict if there will be a recession, we might see a significant decline in the stock market in some time, considering that market is already in the overbought territory. Moreover, slow global growth is a fundamental issue which will continue to add volatility