Our Thoughts on the Yield Curve Inversion
The Trade “war of words” between the United States and China has been yo-yoing markets for the better part of the summer and may continue until both sides come to a finalized agreement. Most analysts agree that the US economy is the best suited economy in the world to withstand a slowdown, but the major concern has been, could a prolonged trade war cause a worldwide recession?
Market participants have been searching for any sign of a recession and yesterday the yield on the 10-year treasury fell below the yield on the 2-year treasury. This is known as an inversion in the yield curve and could be a sign of an impending recession. In other words, investors are demanding a higher return for short term government paper (2yr treasuries) then for long term bonds (10 y r treasuries) which may signal a loss of confidence in the economy. While worries about trade talks have persisted the inversion in yield curve was the first sign of a potential recession.
Dr. David Kelly of JP Morgan conducted a recent call addressing these issues. Below are the highlights from that call.
Dr Kelly estimates that there is 40-60% chance that we avoid recession, but it is the closest we’ve been since the 2008 financial crisis, but any recession would be a mild one. He notes “recession psychology” in which investors hear recession and think of 2008 or hear bear market and think of 2008 or 2000. He does not for see a repeat of either of these events
Dr. Kelly points to the China trade dispute as a primary factor contributing to a potential recession but notes that tariffs are not necessarily the cause but rather the uncertainty around tariffs. A speedy resolution could fix the problem fairly quickly.
Below are the reasons that he thinks a recession could be avoided:
- The US economy is fairly insulated from a worldwide slowdown. He points to the 1998 Asian crisis that didn’t come close to affecting the U.S. The U.S. is mainly affected by what happens within the U.S. economy.
- There doesn’t appear to be any cyclical boom in economy, there isn’t a dotcom bust like 2000 or a housing bust like 2007, 2008. As Dr. Kelly stated, “It is hard to injure yourself jumping out of the basement window.”
- Almost all U.S. recessions have been preceded by rises in oil prices. There are currently no signs of higher oil prices.
- Interest rates are very low. No one is waiting to invest because rates are too high.
- A trade resolution could fix the problems very quickly.
- Banks are much better capitalized than they were in 2008
Below are the reasons why we could go into recession:
- A prolonged trade war with no resolution could increase uncertainty and hinder corporate spending
- Recessions are half confidence and simply talking about a recession could cause a recession
- Fading effects of 2017 Tax Cut. The tax cuts encouraged some investment and consumer spending in 2018 but is beginning to fade and may have pulled from future spending.
- Weak demographics, the working age population growing by only .2% per year. It is this segment of the population that purchases homes, cars, etc.
- Foreign bond buyers are moving into U.S. markets especially Asian buyers. This may be distorting yield curve itself.
Dr. Kelly notes that on a historical basis US stocks are not overvalued and are probably fairly valued based on their current forward P/E ratio.
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