10-year yields in the US over 3% - A signal or a lot of noise for nothing?
The background to this debate is that, as a result of higher interest rates, companies would have to shoulder higher borrowing costs and these costs could have a negative impact on salaries, investment and investor returns. The latter would have the potential, in particular in a rising interest rate environment, to reduce the attractiveness of equity investments and lead to falling stock prices. Beyond the stock markets, an increase in 10-year yields could also trigger a housing market slowdown, as this rate is an important reference for mortgage rates.
Long-term interest rates and inflation in the US
The use of the subjunctive already indicates that all this is not set in stone. Although higher Treasury rates almost inevitably lead to higher (private) financing costs, statistically speaking, there is no reliable signal for a subsequent recession from exceeding the 3% level of 10-year US Treasury yields over the past decades. This is also due to the fact that since the second oil price crisis in the late 1970s and the peak of 10-year yields at around 15.8% in the autumn of 1981, interest rates in the USA have fallen continuously in cycles and in the summer of 2016 even fallen below 1.5%.
However, in recent weeks, there has been growing market appetite that US 10-year yields are at a historic turning point, and as a result of rising central bank interest rates and growing US government debt, there is now a long-term trend towards higher interest rates and worsening problems Stock markets.
In our view, it is still too early to warn against a prolonged period of rising interest rates in the US. While we believe it is likely that the trend of falling interest rates since the 1980s will now come to an end, a prolonged period of strong growth and rising inflation would be needed to keep long-term interest rates steadily rising.
But even in such a scenario, a recession would not be automatic, as strong growth should also lead to higher profits for companies and higher incomes among workers. On the other hand, if inflation rises, our experience is about the speed and volatility of inflation expectations. If the increase is slow and easy to predict, the damage to the economy is likely to be limited.
Danger of an inverse interest rate structure
So are the 10-year US Treasury yields negligible in finding harbingers of the next recession? Not quite! One week ago, James B. Bullard, chairman of the Federal Reserve Bank of St. Louis, expressed concern about the US's flat yield curve and warned of the risk of an inverse yield curve, ie a yield on short-dated bonds above longer-dated bonds maturities.
For example, an inverse interest rate structure can arise if the central bank raises short-term interest rates due to high inflation or economic expectations, and investors simultaneously fear that the economy will weaken and thus invest more in long-term interest-rate securities. The Federal Reserve Bank of New York likes to refer to studies that give this indicator a high forecasting quality for future recessions in the US.
The main reason for the negative economic impact of an inverse yield structure is the dwindling willingness of the banking sector to lend. In such an interest rate environment, banks have to pay more for refinancing than they earn through lending.
At the same time, the demand for longer-term loans is increasing in order to generate profits with short-term investments or to buffer the money in the time deposit account for future investments almost loss-free. The reaction of the banks is then often limited lending or higher risk premiums.
Interest rate structure in the US
As can be seen in the chart "US yield structure" above, the ratio of 10-year yields to 3-month yields over the past few decades has been a relatively good predictor of future economic recessions and deserves attention in macroeconomic research ,
For our risk management, however, this signal only plays a subordinate role, since a looming recession does not necessarily entail falling stock market prices. This can best be illustrated by considering the US stock market index S & P 500.
As can be seen in the following chart, with the addition of the S & P 500, the inverse yield structure provided a good exit point for equity market investors in 2000. However, this success could not be repeated in the 2007-2009 financial crisis.
The inverse yield structure as a risk signal would have already warned equity investors about price falls in July 2006, although in retrospect, the S & P 500 reached its peak 18% above its July 2006 rate only 15 months later, ie in October 2007.
10-year US yields are primarily important to borrowers and government bond investors
In conclusion, we therefore believe that US 10-year returns are primarily important to borrowers and government bond investors. Our analysis has not shown that the yield level of this bond maturity is a reliable indicator of future recessions. The interest rate structure, which correctly predicted recessions several times in the past decades, is suitable for this.
However, even this indicator is only partially suitable as a stand-alone warning signal for equity market investors, since price losses were foreseen in the following two years, but the timing of the exit is difficult to determine.
Nevertheless, this risk indicator should be part of longer-term risk monitoring because, in our view, investors in complex capital markets need to resort to a whole "toolkit" full of forecasting indicators to gain an overview of the economic and financial environment.
Comment by the fund management
by Daniel Hardt, CFA, senior portfolio manager, alpha beta asset management gmbh
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