Take comfort investors: The recession-warning inverted yield curve is gone for now

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The U.S. bond market is no longer signalling economic trouble ahead, bolstering the view held by a number of economists and central bankers that last month’s yield curve inversion – the first of its kind in more than a decade – was likely a brief blip rather than an omen.

“As a signal, just the fact that it goes there is not sufficient. It has to persist there for some time,” Michael Gregory, deputy chief economist at BMO Nesbitt Burns, said.

Mr. Gregory’s comments follow a similarly upbeat view on Monday from Bank of Canada Governor Stephen Poloz, who said during a news conference that historically low interest rates suggest that yield curve inversions – when short-term bonds yield more than long-term bonds – will occur far more frequently than they used to.

“We’re always going to be closer to a flat and low yield curve, and therefore statistically it’s more possible to see inversions that are just innocent ones,” Mr. Poloz said.

The stock market appears to agree. On Wednesday, the S&P 500 and Canada’s S&P/TSX Composite Index both notched fresh highs for the year.

A yield curve inversion is an unusual occurrence that has preceded the past seven recessions, including the 2008 financial crisis. Its predictive abilities may explain why the stock market was initially rattled last month.

On March 22, when the yield on the 10-year U.S. Treasury bond dipped below the yield on the three-month U.S. Treasury bill for the first time since 2007, the S&P 500 fell 1.9 per cent over concerns that the decade-old economic expansion was nearing an end.

The gloom spread to Canada, where the yield curve had also inverted.

But U.S. and Canadian yield curves have reverted to normal, as the yields on 10-year government bonds have rebounded over the past five days, lifting them above three-month yields. That’s raising the question of whether the bond market is now sending an all-clear signal for economic activity and a bullish signal for the stock market.

Some observers remain cautious. Capital Economics expects that previous rate hikes by the Federal Reserve and fading fiscal stimulus from previous tax cuts will lower growth in U.S. gross domestic product to 2 per cent this year, down from 2.9 per cent in 2018.

As well, I/B/E/S data from Refinitiv suggest that U.S. first-quarter earnings for companies in the S&P 500 are expected to decline 2.1 per cent from the first quarter of 2018.

Ed Devlin, head of Canadian portfolio management at PIMCO, one of the world’s largest fixed-income investment managers, said that the reversion to a normal yield curve is reflecting some upbeat global economic developments.

“We had a good GDP print in Canada, after a slew of bad data. You see bond yields in the U.K. rising pretty dramatically today as it looks like the odds of a disorderly no-deal Brexit [decline]. All these kinds of things help with global optimism” Mr. Devlin said.

He added that PIMCO’s baseline assumption is that there will be no recession in either Canada or the United States this year.

Mr. Gregory noted that one of the problems with the yield curve inversion was that it lasted only days and was therefore too brief to be a clear signal of economic trouble ahead. As well, the signal was not met with corroborating evidence by other parts of the yield curve. That is, 10-year bond yields remained higher than two-year bond yields.

He believes that part of the rising concerns over the U.S. economic outlook followed the decline of the stock market late last year, when the S&P 500 fell 19.8 per cent between September and December, which weighed on business confidence and consumer spending.

Now though, lower borrowing costs may be spurring economic activity, particularly in the housing market. And the Federal Reserve may be willing to tolerate rising inflation without resorting to rate hikes to keep those inflationary pressures in check.

“As we are beginning to see more recent data coming out, things look like they are snapping back,” Mr. Gregory said.