ITR Experts Say: Bond Market Raises Red Flags

Last week, the bond market flashed several key warning signs typically associated with worsening economic outcomes. These negative signals corroborate our expectation for decline in rates-of-change across many sectors this year.

In the US, the 10-year Treasury yield fell below the 3-month Treasury yield for the first time since August 2007. This scenario is known as an inversion of the yield curve. Normally, when investors hold a bond with a longer time to maturity, they require a higher return, or yield. The higher yield compensates investors for the increased uncertainty regarding inflation and other risks that accompany the longer time horizon. As uncertainty grows across the global economy, demand rises for safe, high-quality, long-term government bonds. The increased demand pushes prices higher for such bonds, thereby driving yields lower. Bond yields and prices move inversely. A yield-curve inversion signals that investors may be more concerned about long-term growth prospects.

Source: US Treasury Department

An inversion between 10-year and 3-month Treasury yields is commonly seen as a reliable signal that a recession may occur within the next one to two years. According to the Cleveland Fed, a yield-curve inversion has preceded each of the past seven recessions, with only two false recession signals: in 1966 and 1998.

The international bond markets also sent a noteworthy negative signal last week. For the first time in more than two years, the yield on 10-year German government bonds, commonly used as a European benchmark, turned negative on Friday. At the time of this writing, the -0.03% yield was the lowest yield since October 2016. The Europe Industrial Production Index was up just 1.0% from the year-ago level in January and is in Phase C, Slowing Growth. We expect further decline in the Index growth rate to persist into early 2020.

This decline in German bond yields, an important statistic in and of itself, may also place further pressure on the US yield curve. International investors looking for higher, positive yields will likely turn to US Treasuries in lieu of German Bunds. Additional demand for these US bonds will drive prices higher and yields lower.

As always, we recommend that companies consider these warning signs within the context of their own industry trends. Yield-curve inversions and negative interest rates tend to cause a sensation, and they may have a reasonable track record of predicting macroeconomic outcomes. However, following such trends is no replacement for following your own rates-of-change and leading indicators.

Lauren Saidel-Baker, CFA
Economist