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That scary bond market warning about a recession might not be the right thing to be watching after all.
Goldman Sachs strategists, in a note, said yes, the yield curve has inverted, but in an unusual way, and it’s not sending the same powerful recession signal it has in the past.
On Friday, the 10-year to 3-month curve inverted, meaning 10-year Treasury yields dipped below the yield on the 3-month bill, for the first time in seven years.
The Goldman strategists, however, point out that it is unusual for that part of the curve to invert first, while the more commonly watched spread is between the 10-year and 2-year note and that usually inverts sooner. That’s because it’s where the market prices the Federal Reserve’s anticipated interest rates moves. The Fed, on the other hand, favors watching the 3-month spread.
Now, the 2-year yield has been falling more slowly than the 10-year, which dipped below 2.38 percent Monday, and was at 2.44 percent Tuesday.
The Goldman analysts, like others, are blaming the slide in the U.S. 10-year yield on the pressures of the global bond market, where low and negative rates had driven buyers into Treasurys. Yields move opposite price, so they can decline as buyers purchase bonds.
“This dynamic has probably been supported by international spillovers from non-US rates where QE [quantitative easing] and low growth and inflation expectations have supported lower 10y rates,” they wrote. “As a result, the curve inversion signal could be less powerful for recessions than in the past since long dated yields across regions have become more correlated.”
Source: Goldman Sachs
Another important factor to note is that credit spreads did not increase in a material way last week. The Goldman strategists noted that these spreads typically react early to recession risks.
The strategists said they tracked the portion of the curve that is inverted and found it is still weak compared with the last four recessions, when more than 70 percent of the curve was inverted. In the last several months, the 2-year note yield has risen above the 3-year and 5-year note yields, and had been above the 7-year yield.
Investors get concerned when the yield curve inverts because it’s not a good sign for the economy in general. Banks tend to borrow short term and lend to businesses and consumers for longer periods of time, so lending becomes more difficult when short-term rates are higher than longer-term yields.
Source: Goldman Sachs
Stocks and other risk assets can do well with a flat yield curve, and that supports the Goldman strategists’ view that returns will be positive for stocks despite the lack of profit growth and less positive macro environment.
The strategists note that significant market drawdowns began once the yield curve starts steepening, after being inverted.
“Of course this cycle has been different given the ultra low level of rates and so historical results may not carry through directly, but we would expect recession risk remains somewhat low even amid an environment of lower returns” and high volatility, they noted.