A typical bond yield curve shows that longer-term issues yield more than shorter-term ones. But that curve has been inverted since July of 2022 – a situation that usually foreshadows a recession.
Despite this inverted yield curve, neither Canada or the United States has gone into recession. And recently, the yield curve has become considerably less inverted, mostly as a result of long-term bond yields spiking to their highest levels in 16 years.
Does this mean we’ve dodged the dreaded recession and those believing in a soft-landing scenario – in which the economy recovers from a slowdown in a gradual, relatively painless manner – have triumphed in their views?
Not at all. An inverted curve typically flips back to a more normal state immediately before a recession hits. And so after the spikes in yields of the past few weeks, the best opportunities of where to buy in the credit sector have shifted: Longer-term bonds now appear to be a better bet for those investing in the debt market.
Ten-year U.S. Treasuries are currently yielding about 30 basis points below two-year bonds. Just this past July, the spread was more than a full percentage point – a much sharper inversion. (A basis point is a hundredth of a percentage point.)
With the yields on longer-term bond issues rising – the U.S. 10-year, for example, is now at 4.6 per cent – the optimists might suggest we’ve dodged a recession. They see those rising yields as signalling an upbeat view of where the economy is headed, assuming inflation is under control. Stronger-than-expected U.S. and Canadian employment releases on Friday support their argument.
But there are several places to look for recessionary signals in credit markets. Most attention is paid to the spread between two- and 10-year bonds and its current inversion. I think it’s less accurate now as a recession predictor, because we are in an era where central banks intervene more to influence interest rates. They use quantitative easing and tightening, which lessens the effect of market forces. Furthermore, once the curve inverts, a recession will not immediately follow. It historically takes six months to more than two years for the recession to begin and, as we have noted, the curve first inverted in July, 2022.
Importantly, given that interest rates were so historically low for so long, corporations, government borrowers and homeowners with mortgages have sought increasingly longer terms for their debt. Therefore, higher interest rates should be expected to take more time to slow the economy than in the past, when average debt maturities were much shorter.
A recession indicator I prefer is what’s known as the “near-term forward spread,” which is the difference between expected three-month interest rates 18 months from now minus the current three-month yield. That number became negative in March, 2023, and historically it has foreshadowed a recession anywhere from six to 25 months in advance. This indicator has predicted all recessions, in fact, since the mid-1960s.
Either way, we need to be patient to see if that holds true now. Recessions are officially confirmed only after they begin.
In a column I wrote on July 3, I pointed out that U.S. two-year yields were 5 per cent; three-year bonds were 4.5 per cent, seven-year bonds were 4 per cent, and 10- and 30-year issues were just under 4 per cent. Back then, I commented there was little point buying long-term bonds. Investors were not being compensated for holding long-duration bonds beyond seven years because yields beyond that term were about the same.
Even in a rally to a more normal curve, the price performance of three- to seven-year issues would keep up with 10-year issues and longer. I also made the point that despite inflationary pressures, the 3.9 per cent yield on 10- and 30-year bonds at the time was no bargain.
However, with the recent sharp gains in long-term yields – which have not been accompanied by any noted rises in inflation – things have changed. Market timing is always difficult, but if I were still a bond trader, I would be easing in and buying long bonds. These yields won’t go up indefinitely, and investors have oversold them as prices have declined. (Bond prices move inversely to bond yields.)
U.S 10-year Treasuries were, at 0.5 per cent, at all-time lows, just a few months ago. Now they are near 5 per cent. The 300-year average for yields of the world reserve currency is 4 per cent. We went from all-time lows to a full percentage point above the historical average in two years.
You are being paid 5 per cent annually in yield – good insurance in case we have a prolonged bear market, which I believe is probable. And long-term bond prices will rally in time, as is usual, when stocks fall. They always do when equity traders become scared and gravitate to the safer-risk profile of the bond market.
But avoid long-term corporate bonds, especially high-yield ones. Yields will rise faster on corporates, which means their prices will fall faster relative to government issues. These corporate spreads tend to increase dramatically and quickly when stock markets crash.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.