Last week, an email was sent internally to the members of our investment committee entitled: What Does the Bond Market “See”?
The question sought to understand the message that the bond market was apparently sending to investors given the extreme inversion being priced between the yield on 2-year US treasuries and 10-year US treasuries. For a very long time an inverted yield curve has been seen as a very reliable indicator of a forthcoming economic contraction. In broad terms the steeper the inversion the worse the bond market thinks the downturn/contraction will be.
On the day that the email was sent the inversion between 2-year US treasuries yields and 10-year US treasuries yields stood at -107 basis points, a degree of inversion not seen for over 40 years and which would suggest that the bond market saw not just the probability of a bad recession, but actually something closer to a depression.
The reason we (and probably many other) were, at the time, scratching our collective heads at the sight of such an extremely inverted curve was that, superficially at least, all the ‘usual’ economic indicators suggested that, whilst the US economy might well be slowing, nothing yet seemed to suggest the onset of a very severe recession.
Clearly many investors felt that there may be a risk that the Federal Reserve, in its efforts to get inflation under control, might possibly be in danger of pushing too hard on interest rate increases and that, as a result, they might actually end up pushing the US economy into a recession. However, even if that were to happen, based on conventional evidence, a curve inversion (based on historical precedents) of between -50 to -60 basis points was more consistent with that possible outcome.
So, back to the original question, what did the bond market ‘see’ which justified an extra -50 to -60 basis points of curve inversion. Why this added ‘risk premium’ on the 2’s to 10’s curve over where the bond market had previously historically priced the risk of a US recession?
In our mind the most logical explanation for the extreme degree of inversion in the US treasury curve was more likely that the bond market was pricing in the extremely damaging consequences of the extraordinarily loose (and some might say irresponsible) monetary policies witnessed over the last 13 years.
Suffice to say that over this period investors were able to take advantage of the loosest central policies ever seen. As a result, the degree of capital misallocation globally over that period has been quite extraordinary, and the damage this could potentially cause to global economies during periods of higher interest rates had, until recently, not been properly recognised by investors.
The effects of Covid, both economic and psychological, together with now much more entrenched and structurally higher inflationary pressures, have completely changed the investment landscape from that which most people have/had got used over the last 25 years.
Prior to 2021 central banks, politicians and regulators could (and did) take steps to ensure that whenever stresses in the system became manifest the problem was ‘swept under the carpet’ to be dealt with at a ‘later date’. The bond market clearly felt that this ‘later date’ had now arrived and that the ability/desire to constantly backstop markets might no longer apply.
We believe that what the bond markets therefore ‘saw’ 10 days ago (with the 2’s/10’s inverted by -107 basis points) had much more to do with systemic risk and much less to do with ‘conventional’ recession risk. This is because the bond market intuitively understands that higher interest rates always act to flush out capital excesses and that given the extreme level of valuations seen across many asset classes the process of reconnecting valuations with reality was likely to risk systemic contagion.
The very rapid collapse and closure of both Silicon Valley Bank and Signature Bank places into very clear context the nature of these latent risks.
The 2’s/10’s US treasury yield curve has steepened extremely sharply from last Friday’s close and is now ‘only’ inverted by 50 basis points, but the speed and extent of these moves in the US treasury market graphically highlights the very serious concerns investors now have as regards broader market risks, most particularly in the banking sector.
Coming from predominantly fixed income backgrounds we have, fortunately, been paying close attention to what Mr Bond Market was trying to say, and as such we have been underweight equity risk for some time waiting for more attractive valuations to appear. The events of the last week begin to present some opportunities but for now caution is still justified.
Mike Hollings is partner at Shard Capital. The views expressed above should not be taken as investment advice.