When the yield curve inverted last month, talk quickly turned to recession. But on its own, yield curve inversion is likely insufficient as a recessionary warning sign.
Last month, long-term yields fell below short-term yields in both Canada and the U.S. for the first time since 2007. Leading up to the inversion, Avery Shenfeld, chief economist at CIBC, said in a March 4 interview that the flattening yield curve isn’t necessarily warning of recession but is responding to economic indicators.
The flattening curve is “a message in markets that they don’t see the need for a lot more rate hikes at the front end of the curve, which is why short rates have gotten close to longer-term rates,” he said.
The yield curve is picking up on slower economic growth, for example—and so are central banks, which Shenfeld appreciates.
“We were quite concerned late last summer that the central banks in both Canada and the U.S. were on a path that would risk an overkill in terms of the pace and destination of interest rate hikes,” he said. Excessive tightening in borrowing conditions is a recession trigger, Shenfeld explained in a recent report.
For its part, the Bank of Canada (BoC) raised its key rate five times from mid-2017 to October 2018. But going forward, a more measured approach is expected.
“Both central banks now seem to be recognizing the reality of this cycle,” Shenfeld said, “which is that neither the U.S. nor the Canadian economy is showing enough momentum to make a convincing case that they can continue to do well with sharply higher interest rates.”
The BoC has held its key rate since the October hike, and at its last rate announcement on March 6 it said the economic outlook continues to warrant a policy interest rate below the 2.5% to 3.5% neutral range. When the Fed last held its key rate on March 20, it projected no hikes this year.
And 2020 could even see a Fed rate cut. With U.S. fiscal stimulus expected to fade that year, “we might well see the Fed cut interest rates a quarter point to keep the economy from dipping into more of a slowdown than they were bargaining for,” Shenfeld said.
He also noted that yield curve inversion is characteristically different from previous periods—another reason not to sound the recession alarm bell.
“The new normal for long-term interest rates is lower than it was in the ’70s and ’80s,” he said, “because markets no longer fear the risk of an escalation of inflation and no longer demand the same set of term premium to lock in money over the longer term.”
A better indicator of recession would be “a steeply negative slope for the yield curve, coupled with a softening in employment data,” he said.
Yet, 10-year yields are now just above three-month yields in Canada and the U.S., and jobs growth is solid. In Canada, jobs growth over the first quarter of 2019 was the strongest since late 2017, and the U.S. economy added 196,000 jobs in March.
Said Shenfeld: “We don’t have either of those signals yet for the U.S. or Canada.”
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