Janus Henderson: Thoughts on US / Chinese yield curve signals

Major equity market declines historically were associated with US / global recessions. The US Treasury curve (10s-2s) inverted well before every recession since the mid 1950s but has yet to do so. The term premium, moreover, is unusually low, meaning that the flatness of the curve exaggerates monetary tightness. The curve, in other words, needs to become significantly negatively sloped to indicate a recession. Once this occurs, investors will have time to derisk portfolios before markets weaken.

This argument is dangerous for several reasons.

First, equity markets usually decline before / during economic slowdowns as well as recessions. Slowdown-related falls can often be severe, e.g. the 1966-67 US economic slowdown was associated with a 22% peak-to-trough decline in the S&P 500. Investors should dial down risk ahead of slowdowns as well as recessions, to the extent that either can be anticipated.

Secondly, the focus on the US yield curve may be misguided. The current global slowdown originated in China / Asia and has spilled over to Europe. The Chinese yield curve inverted in mid-2017 – see first chart.  It is possible that this will prove to have been the recession warning signal in this cycle, with the US curve lagging.

The last Asian-driven global economic slowdown was in 1997-98. It did not develop into a recession partly because of US / G7 monetary policy easing and partly because the region was a smaller part of the global economy. Asia ex Japan now accounts for 37% of world GDP at purchasing power parity, up from 19% in 1997, according to the IMF.

Thirdly, monetary trends argue against the view that the yield curve signal has been distorted by a low term premium. The slope of the G7 curve has been closely correlated historically with the six-month rate of change of G7 real narrow money – second chart. The two measures are giving an identical message at present – both suggest restrictive monetary conditions. If the term premium had introduced a distortion, one would expect real money growth to be diverging positively from the curve (assuming, reasonably, that the premium has little impact on money trends).

Fourthly, the argument that investors have time to adjust their portfolios after a yield curve inversion may be correct in principle but the relevant curve now may be China’s. The MSCI All Country World Index peaked in January 2018, eight months after the Chinese inversion.

The normalisation of the Chinese curve since mid-2017 suggests that China / Asia will lead a global economic recovery but Chinese money trends currently remain weak, arguing that any revival is unlikely until the second half of 2019 at the earliest.​