If 2019 was the year the yield curve went mainstream, with an inversion sending a stark recession warning, then 2020 is already shaping up as a welcome return to normality.
Nobody is willing to call the all-clear on the global economy yet given a trade deal between the US and China is still to be reached. Even so, the prospect of longer-term yields stretching their premium over shorter maturities is among the top trade ideas for next year on Wall Street, drawing money from the likes of BlackRock Inc, Penn Mutual Asset Management and Aviva Investors.
“The curve, from two- to 10-years, will probably be modestly steeper in most places,” said Praveen Korapaty, chief global rates strategist at Goldman Sachs Group Inc. “This is largely because some of the tail risks that people were worried about have at least reduced. It will certainly be different from this year, where in most parts of the world there was pretty strong flattening.”
A global bond rally this year drove the yield on 10-year Treasuries below those on two-year securities in August, for the first time since before the last financial crisis in 2007, and the last five such occasions a contraction followed. The inversion and a potential recession became a hot topic in Google searches and around the dinner table, yet the economic contraction hasn’t arrived so far after central banks stepped in with more stimulus.
Global share prices also aren’t indicating trouble ahead on the economic front. US equities reached record highs Tuesday, while Japan’s Topix Index touched a 13-month high.
History also shows that such inversions can flash “false positives” on the indication of a downturn, and for PGIM Fixed Income chief economist Nathan Sheets, that’s the case this time around. While a recession typically emerges about 12 to 18 months after an inversion, Sheets still doesn’t see a downturn in that time frame.
“The global economy has skirted the recession threat,” Sheets said. World economies “have been hit with a broad range of geopolitical shocks and uncertainties in recent years and have just kind of continued to barrel along at what I call mod-lustre –- something between modest and lackluster -- growth.”
The Federal Reserve Bank of New York’s recession probability gauge, which uses the three-month to 10-year Treasury curve to predict the chance of a US contraction in the next 12 months, plunged last month. The gap between two- and 10-year Treasuries is now at about 15 basis points, versus minus seven basis points in August.
In Europe, Germany narrowly averted a recession last quarter, and its bellwether yield curve has also steepened after coming close to inversion. Growth remains depressed in the UK and Japan, whose curves both inverted in August, but since then, long-end yields have risen more than the front of the market.
Anchoring short-term yields are signals from global policy makers that they are taking a pause after 2019’s monetary easing. Fed Chairman Jerome Powell and his colleagues say policy is in a good place after 0.75 percentage point of interest-rate cuts this year, and have indicated there’s a high inflation bar for any tightening. European Central Bank President Christine Lagarde is likely to pressure governments for fiscal support as she has limited scope to trim rates further.
Curve steepening in the $16.5 trillion Treasury market is favored by TD Securities and NatWest Markets, which recommends positioning for it in the five-to-30 year sector. The same stance in German bonds is among the top trades next year for strategists at Morgan Stanley. BlackRock expects overall steepening in countries including the US and the UK.
“We switched in Treasuries from a flattener to a steepener in the middle of this year and added to the position this quarter,” said Zhiwei Ren, a portfolio manager at Penn Mutual, which oversees $28 billion. “The economic long-term trends indicate that there will either be a secular slowdown or secularly higher inflation. The steepener should work in both of those environments.”
The picture is similar elsewhere, albeit for different reasons. In the UK for example, the potential of Boris Johnson gaining a majority in next month’s election and passing his Brexit deal could help stimulate an economy that has been held back by the possibility of crashing out of the European Union.
On top of that, both Johnson and Labour leader Jeremy Corbyn have pledged to increase spending, likely leading to a sell-off at the long-end of the curve as more debt is issued. The only thorn in a steepening strategy would be if the Bank of England sees inflation pressure and hikes rates, though at the moment money markets are betting on a cut by the end of next year.
There’s likely to be a “Boris boom,” said Russell Silberston, a money manager at Investec Asset Management, referring to the possibility of a large sell-off in gilts and a steepening of the yield curve. “I would expect it to come into focus when the market puts two and two together -- getting a withdrawal agreement done plus a huge fiscal boost.”
Across Europe, the prospects for steepening are more difficult to pin down.
A cooling in trade tensions could see investors continue to shed haven positions in German bonds -- making bets on steepening likely to work out. Yet if the economic data worsen and fiscal support doesn’t emerge, Lagarde may boost quantitative easing rather than pushing rates deeper into negative territory. That will likely favor the longer-dated bonds of some of the region’s most indebted countries, such as France and Italy.
“In Europe, further easing is likely to be more with QE and forward guidance,” said Joubeen Hurren, a money manager at Aviva Investors, who is betting that yields on 30-year French bonds will fall more than those on 10-year securities to flatten the curve. Lower rates in the US have more scope to steepen the curve there, he said.
In Japan, the two-year versus five-year yield curve came out of inversion this month for the first time since April, and longer-dated yields are also rising. The 10-year yield has climbed to approach the 0% level around which the Bank of Japan has built a curve control policy.
For now, an array of global data filtering in have raised the potential for the global economy to shake off the message from this year’s inverted curves and recession warnings from some prognosticators.
Futures traders are pricing in the possibility of the Fed making one more cut in 2020, as policy makers seem to envision the three cuts this year as just a mid-cycle adjustment. BlackRock sees that supporting its view that the US curve will steepen next year.
“It’s very hard to see a meaningful shift in terms of Fed pricing,” said Marilyn Watson, head of global fundamental fixed-income strategy at BlackRock. “The US yield curve is still pretty flat. And the drivers for that, structural investors -- pension funds and foreign investors -- that have continued to put pressure on back-end” yields, should wane and cause the curve to steepen.