Next Recession: What’s the Bond Market Say?
Patrick O’Toole, Vice-President, Global Fixed Income, CIBC Asset Management
“We've seen a lot of articles written about recession risks are rising, and it's really coming from the bond market. And one thing people look at to get a sense of when the recession may be coming, is the difference between a 2-year bond yield and a 30-year bond yield. When you see that 2-year bond yield rise above the 30-year bond yield, then people started thinking, a recession is imminent. And that's been true. If you look back the last 40 years in the U.S. in particular, whenever that's happened we've had a recession on average within about 18 months. So we're not there today. Right, so there's nothing to get overly worried about now, but it's getting closer. If you look back at 2013, the difference between those two yields was about 3.5%. But at the end of last year we went below 1%, we got to about 0.8%. So when it gets below 1 everybody starts paying a little more attention, and you start watching for signs that you could go inverse as we say, where the 2-year actually rises above the 30-year yield. And in Canada we're even more so focused on it because the difference between those yields is even lower than it is in the U.S..”
How many rate hikes?
“We’re in an environment today where the Federal Reserve is talking about hiking again two maybe three times in the next six, nine months. Watch that yield curve. If it inverts, as we say and that 2-year yield rises above the 30-year that's your warning sign. It's been a tried and true sign. It could be that we're there before the end of 2018 or maybe early 2019. And probably when and if it does happen, you'll start to hear some pundits say don't worry about it, you know, this is not like we've seen in prior cycles, this whole cycle has been different and the Federal Reserve, other central banks have been taking extraordinary measures, doing different unique things this time. I'd say you know stick to what's batted 1000 so far. For the last 40 years, in the U.S. in particular, when 2-year yields have risen above 30-year yields you've had a recession within about 18 months. So I'm still going to stick to that.”
Bond market signals on growth & inflation
“I think if you're sitting here today and you're looking at what the yield curve is telling us, it's still saying, you're in an economy that's growing. It's just growing at a slower pace than what we’ve seen in the past several years. So we're expecting, as I said, growth in Canada to be a little below trend or a little below consensus around trend. The U.S. may be a little better than trend, but a little below consensus again, I think the bond market is telling you that. The bond market is also saying inflation is not that big a worry. Some people are getting very worried, particularly earlier this year that inflation was going to become a bit of an issue. Wage prices moving up a little bit and that's been a telltale sign in the past that inflation is coming, but we're not seeing anything to get overly concerned about there also.”
Now in the late part of the economic cycle
“It is true we're late cycle. This cycle has been one of the longest ones in the post-World War II era, second longest cycle. Oil prices are moving higher. Inflation is perking up a little bit. The improvement in the job market is slowing down. A lot of merger and acquisition activity going on. So all of these classic late cycle signs are something else to get you a little more worried that a recession is coming. But we're not at that point yet where we have to get overly concerned.”
Short-term vs. long-term interest rates
“So generally what you see is short-term interest rates the 2-year, the 3-year, the 5-year will move in anticipation of the Federal Reserve raising its interest rate and move along with the Fed hiking its interest rate. Long-term bond yields, 7, 10, 30-year bond yields, they're not as linked to the short-term interest rates as some people might think. They're still more linked to what's going on in the economy and what's going on with inflation expectations. Short-term interest rates have moved up with the Fed hiking its interest rate since December 2015, they hiked their first time. So short-term rates have moved up in sync with that and long-term rates have risen a lot more modestly because inflation has stayed very contained.”
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