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Last summer, the bond market sent a warning. Was it a false prophet?


David Absolon

Investment Director
10 min read

Back in July 2019, we wrote about an inversion in the yield curve in US government bonds, where yields on 2-year bonds briefly surpassed those of 10-year bonds. We noted that this kind of event has historically been seen as an indicator of future recession.

Last summer, the bond market sent a warning. Was it a false prophet?

Last week, the yield curve inverted on a much rarer pairing of US government bonds – the 3-month and the 10-year. Given this news, coupled with the fact that six months have passed since our last communication on inverted yield curves, do we think a recession lies around the corner?

What is a yield curve inversion? (A brief explainer)

  • A bond’s yield is the regular interest payment made to its holder, plus the capital returned when the bond matures.

  • A yield curve plots the difference (spread) between yields offered on similar bonds with different points of maturity (e.g. the yields on 2-year government bonds versus 10-year government bonds).

  • When the yields of longer-dated bonds fall below those of their shorter-dated counterparts, it shows that investors are asking to be paid more to lend out their money for a shorter period than for a longer one.

  • This points to significant uncertainty surrounding near-term events, and is called a ‘yield curve inversion’.

Are yield curves worth watching?

As we remarked last summer, yield curve inversions have predicted more recessions than have actually materialised. There has also been with significant variation (from months to years) in the time elapsing between the curve’s inversion and a recession.

This doesn’t mean that these indicators are worthless – in fact, yield curve signals can be very useful to investors. Yield curve inversions may be slightly hit-and-miss in their ability to predict future recessions, but they are often very accurate in reflecting the real-time investment market landscape.

And investors are not the only ones reading the tea leaves when it comes to bond markets. Economic policymakers are watching too.

What has changed since July?

Over the summer, with US-China trade tensions at a peak and global economic growth showing signs of faltering, the yield curve inversion flashed a very specific warning light to the US central bank. Yield curve inversions often highlight growth-restrictive policies from central banks, and the US Federal Reserve (Fed) appeared to receive the message – along with signals from other economic data – that it needed to act.

Having opened 2019 in the turmoil of ill-received interest rate hikes, the Fed shifted gear abruptly over the summer. Fed policymakers cut interest rates three times in three consecutive meetings, and even chose to begin injecting liquidity into short-term money markets to support the economy.

Other central banks began to react to weakening conditions too, with concerted efforts to push money into their economies and cut interest rates to stimulate lending and activity. Over the following months, relations between the US and China also improved, ultimately leading to broad agreement over Phase One of a trade deal by the end of the year (signed in January). More latterly, green shoots of growth have emerged in key areas of the global economy, suggesting that – rather than recession – the current period of economic expansion may have been extended.

In this environment, the yield curve inversion between 2- and 10-year US government bonds righted itself very quickly. And set in a wider context, we would note that the inversion was both swift and small, unlike other inversions which have proven prolonged in length and severe in magnitude. Indeed, until recently, the bond yield curve had been looking much more rational and healthy (i.e. longer-dated bonds had significantly higher yields than their shorter-dated peers). Last week, though, this normalisation has faltered, and investors witnessed another yield curve inversion between 3-month and 10-year bonds. Why has this occurred?

Key bond yield curves have inverted at different points in the last six months
(US government bond yields)

US Yield Curves

Past performance is not a reliable indicator of future results. Source: Macrobond

We would argue that, even more so than in the summer, the bond market is reacting to very immediate concerns, rather than long-term signals. In this instance, we think the market is reacting to nervousness around the coronavirus and concerns about its impact on the Chinese economy. While this global health worry is far from over, currently our expectation is that the economic fallout will be without significant long-lasting effects on the global economy.

What should we expect next for bond markets?

2019 was a fantastic year for bond markets across the board, but we shouldn’t expect a repeat of this in 2020. In the wake of a good 2019, bond prices begin 2020 much higher than 12 months earlier (and yields are therefore much lower now than at the start of 2019). This makes a significant further move up in bond prices this year much less likely.

Noise surrounding the coronavirus may have led investors to return to the relative safety of bonds of late, but we don’t expect this to be a sustained trend. Equally, we do not foresee any material deterioration in the global economic backdrop in the near future, removing another possible trigger for a flight to ‘safe haven’ assets like bonds.

We think corporate debt – rather than government bonds – shows the most potential for returns in 2020, alongside key areas of emerging market debt. The latter could be helped by economic growth beyond US shores, which would lead to a slightly weaker US dollar versus its global peers – good news for emerging markets, which often issue their debt in the US currency. The holdings in our investment portfolios reflect these preferences, and our economic vision for the months ahead.


About the author

David Absolon

Investment Director

David re-joined Heartwood in 2008. He manages the Defensive investment strategy and is Co-Head of Fixed Income Research. He is also a member of the Tactical Asset Allocation team and Head  of Investment Research

  • 2006 - 2008: Investment Strategist Barclays Wealth.

  • 2002 - 2006: Investment Manager, Heartwood Wealth Management

  • 1999 - 2002:  Investment Manager, Rathbone Investment Management.

David holds a Bachelor of Law and a Postgraduate Diploma in Legal Practice from the University of Bristol. He is also a chartered fellow of the Chartered Institute for Securities & Investment.

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