US equities: yield curve sends recession signal

In the USA, key interest rates are higher than long-term capital market rates. A similar trend is emerging in some other industrialized countries. This „inverse“ yield curve turns the usual mechanisms in the lending business upside down. This is because the longer the agreed term of a loan, the higher the interest rates on it. If this correlation is reversed, i.e. if the interest rate with the longer term falls below that of the shorter term, this can lead to economic problems for companies. For example, banks can no longer earn money through „maturity transformation“. In this process, short-term customer deposits are lent at a higher interest rate than loans. The situation is more difficult for banks within Europe. Although the yield curve in the individual countries is not yet inverse here, the banks pay penalty interest on deposits with the European Central Banks, which they generally do not recoup from their investors.

Even without this direct effect on banks, the formation of inverse yield curves is a warning signal for the economy and stock markets. Despite low yields, investors secure these in the long term because they expect interest rate cuts „at the short end“ – as the last reaction of the central banks to prevent a recession. In recent weeks there has been a real „hype“ about the inverse yield curve as a warning indicator of an impending economic slowdown, because in the USA the yield curve has turned before each of the past recessions since 1955.

In principle, a rotating yield curve in the past has had good predictive power for an impending economic slowdown. However, it often took months or even years for the recession to set in. There were also false signals, among others in 1966 and 1988, when the yield curve inverted but there was no recession. A good counter-example is also the current events surrounding the German economy. This economy is probably on the verge of a mild recession, without the yield curve having turned before.

It is also possible that the quantitative easing programs of the US Federal Reserve („QE“) have reduced the signal suitability of the yield curve. QE was developed to push long-term bond yields below an economically „neutral“ interest rate.

Something else is different this time: the current upswing is much less buoyant than in the past. In addition, the expansionary monetary policy has caused the key interest rate level to fall significantly lower than in earlier phases of inverted interest rates, in which the „Fed Funds“ were several percentage points higher than today. At that time, a change in key interest rates had a much greater impact on companies‘ cost of capital than it can today.

There are reasons to hope that the US economy will not go into recession. Rising key interest rates usually lead to an end in the economic upswing and the file market upswing. However, we are currently a long way from this because the Fed remains expansive. Unemployment is low and most people looking for a job find one. As a result of the stable consumer environment, consumers, like the government, are spending heavily and are supporting the economy. This counteracts the slowdown in economic activity in the manufacturing sector, largely caused by the self-initiated trade conflict between the Americans and China. The New York Federal Reserve also sees a 67% probability that there will be no recession in the US in the immediate future.

A backtest in the Bloomberg system shows that investors who between 1988 and today would have managed their stock positioning („long“ or „short“) according to the degree of inversion of US yields would have received many false signals that would have led to losses. The inverted yield curve is therefore not a suitable indicator for forecasting the further development of US share prices, but rather a consequence of the uncertain economic outlook in the industrial sector (including the trade dispute), the oversupply of markets with central bank liquidity and the generally extremely low level of interest rates.

In general, the absolute level of interest rates also has a stronger effect on earnings development and the valuation that can be granted to the stock markets, not the degree of curve steepness. Investors should also look at other indicators, especially corporate earnings performance and the further development of the trading dispute.
In general, the marginal utility of falling interest rates has been diminishing for companies over the past few years. Lower interest rates have a greater impact on the use of funds (e.g. dividend payments and share buybacks) and the general mood on the markets than on companies‘ business plans. In the medium term, we expect that the influence of the current hysteria of interest rate cuts will escape from the stock market again. Neither the earnings outlook nor the stock market valuation support a significant rise in the indices until the end of the year. This applies particularly to the US equity market, whose weak earnings momentum is borne almost exclusively by securities from the technology and banking sectors and whose valuation is increasingly hitting historical upper limits.

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