It is a year since the US yield curve became inverted, with the yields on ten-year Treasuries falling below those on two-year paper. The last time the US yield curve was inverted like this for a year was in the early 1980s. Like then, now is also a seminal moment in the policy debate.
Traditionally, an inverted yield curve is viewed as a harbinger of recession. In 2018 research from the Federal Reserve Bank of San Francisco showed all ten US recessions since 1955 had been preceded by an inverted curve. We have had the pandemic since. The reality though is that while most recessions are preceded by an inverted yield curve, not all inverted yield curves are followed by recession. Indeed, that study showed one false signal. Also, it was the leading economist Paul Samuelson who commented back in the 1960s that the bond market has predicted nine of the last five recessions.
Such market signals need to be heeded, but are not always accurate. Currently, two-year US yields are 4.93% and ten-year yields 3.85%: an inversion of 1.08%. It is also indicative, in our view, of a marked shift away from a focus on inflation to one on growth. The markets, like policymakers, are vigilant about persistent inflation but also recognise the inevitable squeeze on growth from monetary policy tightening.
A similar message in the UK
Like the US, the UK faces a similar message from the market. Two-year bond yields in the UK are 5.34% but ten-year yields are 4.44%. Thus, the UK yield curve is very inverted, too: -0.90%. The markets are very much telling us something and they are probably right. Namely, the economy is fragile, and a recession cannot be ruled out. The markets are, of course, predicating this on policy rates heading significantly higher. We see a recession being avoidable if the Bank avoids over-tightening.
Currently, the Bank of England’s policy rate is 5%. The markets expect 6% by November and have not ruled out 6.25% as the peak, with rate expectations around 6.2% for year-end. It may yet be possible for policy rates to peak at a lower level, say at 5.5% or less. Whereas the Fed was able to pause recently, with headline US inflation down to 4% from a recent peak of 9.1%, the Bank of England had to hike from 4.5% to 5%.
That move was necessary in the wake of recent poor UK inflation data: two poor recent headline inflation figures; a rise in core and service sector inflation; an acceleration in wage inflation; and the market’s lack of confidence in the UK’s anti-inflationary stance. Now, the Bank may find it is pressurised to keep hiking until core inflation is seen to have peaked. Yet, the higher rates rise the more likely it is that they will have to be cut following the inevitable slowdown, when the effect of policy tightening feeds through, impacting both households and firms.
The issue for the markets, though, is not just where rates peak. Historically, tight policy is often associated with positive real rates (where rates are above the rate of inflation). In our view, another issue for markets is that in future policy rates will need to settle at a higher level than in the recent past, to avoid a return to cheap money and its damaging consequences of asset price inflation, markets not pricing properly for risk and a misallocation of capital, and to prevent inflation pressures building again.
It is hard to say where this will be, but in all likelihood, it will require policy rates settling at a higher level than inflation. That would also imply that policy rates are not cut at the first sign of economic weakness or financial fragility as has often been the case in the past.
These challenges are compounded as a decade and a half of cheap money will leave key sectors of economies and markets exposed to monetary tightening. That was evident last autumn with the pension funds’ crisis and there are many who are concerned about a mortgage crisis. It is not just economic and financial uncertainty that markets will have to contend with, but political uncertainty, too. The inflationary 1970s were a prelude to political change and turmoil across the globe and the same could unfold now. The failure of policymakers to get on top of inflation can impact living standards and feed political instability.
Despite such uncertainty, there are positives. While headline inflation remains high it still looks set to decelerate sharply, helped by easing energy prices and a deceleration in producer and in food prices. If so, this will help spending power. Core inflation, though, is stubborn, largely in part because of high service sector inflation. Domestic services may be less exposed to external competition, allowing prices to rise.
Even though UK economic growth is sluggish, another positive is that the economy has shown remarkable resilience. Recession has been avoided. Consumer confidence, too, has started to recover, with the GfK measure still low at -27 but up from -49 last September. In May last year it was -40. Also last May the index of “personal finance situation” was -25 and is now -8.
This may reflect that for some people savings remain high following the pandemic, that wages are recovering, and it may reflect the ongoing strength of the labour market. Indeed, a resilient jobs market and solid consumer confidence may help avoid recession. But weakness is very apparent in the manufacturing sector, where the PMI measures are both below 50 and the last three months show negative momentum.
Against this is the danger that monetary policy may have already tightened too much. We have stressed this before, noting that there is considerable policy tightening in the pipeline and that monetary policy works with a long and variable lag, of perhaps 12 to 18 months. Hence we think the Bank should avoid hiking too much.
By early next year, though, inflation is likely to below policy rates, even if they peak at 5.5%. The Bank has little credibility. Its communication has been poor, its forecasting wayward. Yet, even that need not mean that inflation cannot decelerate sharply and recession be avoided. Importantly, we have moved from the situation a couple of years ago when monetary policy was clearly wrong – and that was evident at the time – to a situation now where the actions of the Bank are a more finely based judgement call.
In conclusion, we believe there is a need to avoid a future return to cheap money as that has caused many problems, which are impacting now. But in arguing that, it is also important to avoid seeing it as a reason to keep tightening monetary policy, as two wrongs do not make a right. The Bank of England was wrong to not tighten two years ago, when inflation pressures looked set to persist. Now the danger is if they over-tighten.
The inverted yield curve, where ten-year yields are lower than two-year yields, suggests that the markets believe the economy will slow. Admittedly the markets are basing this on policy rates rising sharply further, but even now, at 5%, there is significant policy tightening in the pipeline. We would advocate not tightening further and keeping rates then high for some time. We expect policy rates to rise and peak at 5.5%, but if rates peak at the rate implied by the market then a recession will follow.
Please note, the value of your investments can go down as well as up.