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Inverted US yield curve and falls in equity markets

The US yield curve has inverted between 2 and 10 years, which has been the catalyst to the latest equity market correction. This takes place in an environment of slower global economic growth and escalating geopolitical uncertainty.

What happened?

  • The US yield curve inverted between 2 and 10 years. That is, the US Treasury 10 years yield was lower than the US Treasury 2 years yield. This negative slope of the yield curve was a modest 2 basis points at the end of trading yesterday (15 August). An inverted yield curve is an important event as historically, it has been a very reliable indicator of an impending recession. History tells us that once the 2s-10s curve inverts, on average a recession is approximately 12 to 18 months away.
  • Markets were alarmed by a number of disappointing economic data released yesterday. German June quarter GDP shrunk by 0.1% and Chinese June industrial growth (4.8%) was at its lowest level since February 2002.
  • While the inversion of the US yield curve is the catalyst to the latest equity market correction, this takes place in an environment of slower global economic growth and escalating geopolitical uncertainty.

MARKET REACTIONS

  • US equity markets fell sharply over night (14 August). The S&P 500 Index fell by 2.93%, the Dow Jones Industrial Average fell by 3.05% and the NASDAQ fell by 3.02%. US equity indices recovered modestly in trading on 15 August.
  • Equity markets in Asia Pacific have also fallen in trading today (15 August). The ASX 300 Index fell by 2.67%, the Nikkei Index by 1.29%. Surprisingly, the Hang Seng has bucked the global trend and rose by 0.76%.
  • Long maturity bond yields in the main developed markets have fallen dramatically over the past 12 months: US 10 years bond yield has fallen to 1.51% from 2.86%, Australia 10 years bond yield is now at 0.86%, down from 2.57%.
  • The AUD is currently trading at around 0.677 USD.

IMPLICATIONS

  • The inversion of the US yield curve reflected investors’ concerns about the slowdown in global economy. In summary, the three largest European economies (Germany, Italy and France) have all seen economic slowdown. The outlook for the Chinese economy is clouded by the escalating trade tension with the US. In addition, the Chinese government has not stimulated the economy as aggressively as some investors had hoped due to concerns about high level of indebtness in the economy.
  • The US economy is in a more solid position, at least relative to the other major economies. While US economic growth has moderated since the start of 2019, the level of unemployment remains very low and inflation, while accelerating, remains under control. The benefits from the Federal Reserve’s pivoting from a tightening monetary policy to a more accommodative policy stance are yet to flow through to the real economy.
  • It is too early to predict a recession in the US over the next 12 to 18 months with certainty. The Federal Reserve is in a better position, compared to the European Central Bank or the Bank of Japan, to provide the necessary support to the economy due to the simple fact that the US still has positive bond yield! In fact, unstable financial markets may lead the Federal Reserve to ease monetary policy more aggressively.
  • It is important to note that the recent sharp fall in 10 years US Treasury yield cannot be explained by economic fundamentals alone. There is a sharp rise in investors’ risk aversion and US government bonds, as a safe haven asset, benefited from this shift in investor sentiment.
  • Geopolitical events play a role in the shift in investor sentiment. The main geopolitical uncertainty and risk to the global economy remain the US China trade dispute. Ironically, the US announced on the morning of 13 August that the proposed 10% tariffs on USD 300 billion imports from China will be delayed until 15 December for some items. Those items are mainly consumer goods (mobile phones, laptops and toys) and total around USD 150 billion. This positive development seems to have been overwhelmed by other geopolitical developments including: 1) the deterioration of the political situation in Hong Kong; 2) the increasing likelihood of a ‘Hard Brexit’.
  • In summary, the possibility of a US recession has increased recently, but it’s not a certainty. This partly reflects geopolitical tensions which pose significant risks to the global economy. Investors can expect further volatility in equity markets given that many of the geopolitical uncertainties are unlikely to be resolved quickly.

Written by George Lin, Senior Investment Management, Colonial First State

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