Is inverted yield curve still accurate predictor of recession?

Top market strategist urges bears to calm down and says Canada weakness mirrored by US and in Europe

Is inverted yield curve still accurate predictor of recession?

The bears were more agitated than normal when Canada joined US in experiencing the dreaded inverted yield curve as fears of an impending recession heightened this week.

The yield on Canada’s 10-year bond dipped 10 basis points lower than the rate on the three-month Treasury bill on Monday, compared with a gap of 6 basis points on Friday.

It’s an inversion that hasn’t happened since 2007 at the dawn of the financial crisis, reflecting concerns of a widespread global slowdown that will keep both the Federal Reserve and the Bank of Canada from raising rates and could maybe even result in a cut.

But Dave Lafferty, Natixis chief market strategist, wants everyone to calm down a little. “The bears love to point at the yield curve and make it seem like a foregone conclusion that this means a recession is imminent; I’m not in that camp.”

Lafferty stressed that simply looking at the curve’s link to recessions and downturns fails to take into account the characteristics of the post-2008-09 financial crisis economy.

He said: “I think the yield curve is still a really important indicator but we have to recognise that post-financial crisis there is so much central bank interference across developed market yield curves that while it’s an important indicator, I’m not sure its predictive power is as strong as it used to be.”

He added that saying a recession is close is overstating things, while ruling it out is “Pollyanna-ish”. Lafferty is somewhere in the middle of those two camps and said it’s important to recognise that the use of forward guidance and quantitative easing, among other tools, has likely suppressed longer-term yields more than they would otherwise be in unfettered markets.

“We never know the truth of [an inverted yield curve] but we know markets will react to it, just because expectations are that the slope of the yield curve really matters,” he said.

“I’m not sure it’s as indicative as in previous cycles but that’s not going to matter to the market – that’s going to worry about it because of its historical accuracy.”

The pessimism over the Canadian economy’s growth – or lack of – is not disputed by Lafferty but he did point to other developed markets as proof that the country is far from an outlier. Weakness in the data is mirrored by the US, Germany and the Brexit-riddled UK.

He said: “We see most developed economies at this point as gradually decelerating and, to me, the Canada story is very similar to what we see in other major developed markets. I am not sure Canada is offering some kind of idiosyncratic risk that other economies in the world aren’t experiencing as well.”

In terms of how an investor should be treating their portfolio, Lafferty said the curve inversion should not change the big picture.

“We are a little late in the cycle to be sticking our necks out. While we think the markets can grind higher in most developed markets, earnings expectations are still positive – I think you can still make money in US equities, European equities and Canadian equities but I don’t think you want to be sticking your neck out this far in the cycle.”

He admitted the housing market needs to come back down to earth and to concerns over the weak Canadian dollar but he urged investors to look at the global landscape.

“There is a risk we are decelerating as a precursor to recession but that isn’t our base case. It’s a possibility not a probability. When we say be cautious at the end of the cycle, what we are really saying is you can hedge recession risk but you shouldn’t be betting on recession risk.

“It isn’t a greater than 50% probability – at least in the near term. Obviously, there is going to be a recession at some point – we just don’t see it on the near horizon.”

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