Amid optimism about progress on US-China trade negotiations and on the back of stronger ISM US non-manufacturing data, 10-year Treasury yields rose by 8 basis points (bps) on 5 November. Yields are approaching the September highs of 1.9%. The two-year/10-year spread also rose to 23bps, its highest point since July.
Do higher yields and a steeper curve mean recession risks have receded?
The 2/10 yield curve briefly inverted in August, but has gradually steepened since. In our view, yield curve inversions are not an infallible predictor of a recession. Of the last 10 times the curve inverted, there was no recession for the next two years after three of them. Even when recession follows inversion, there is a long and variable lag. Recessions start, on average, 21 months after inversion, with a range of 9–34 months. Equally, a modest re-steepening of the curve does not mean recession risks have materially changed.
It is more important to consider the impact of yields and the curve on lending behavior. The Federal Reserve's quarterly survey of bank loan officers, released on Monday, shows that banks very slightly tightened lending standards for commercial and industrial customers in the third quarter and have continued to move away from a loosening stance in 2017–18. However, the reading still remains comfortably above levels just before the last two recessions. Banks may not be loosening lending terms, but they are not tightening them, either.
The flattening—and brief inversion—of the yield curve this year hasn't prompted banks to pull back in a meaningful way. Similarly, the Fed's multi-year hiking campaign that ended in 2018 also hasn't impaired access to capital, and the Fed's three rate cuts since July are likely helping incentivize banks to continue to lend.
The recent move in yields largely reflects trade optimism. In the short term, the announcement of a Phase 1 trade deal between the US and China could see rates take another leg higher. However, we think any such move will be limited given our view that the Federal Reserve will not be raising its policy rate any time soon. Our assumption is that after a Phase 1 deal, interest rates will resume drifting lower, given that we see no structural increase in growth or inflation on the horizon.
We expect rates to remain lower for longer. We forecast US 10-year yields at 1.60 at end-March 2020 and 1.70 at end-June 2020. In this environment we are focusing on earning yield. We prefer USD-denominated sovereign bonds to stocks in emerging markets, and in our FX strategy we overweight select high-yielding emerging market currencies versus a set of lower-yielding currencies.