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Is the Yield Curve Inversion Really a Big Deal?

Updated: Jul 20, 2023

The recent inversion of the US Treasury yield curve has gotten a lot of people fired up this week. Yesterday, the yield on the benchmark 10-year Treasury note went below the 2-year yield at 1.634%, and the yield on the 30- year Treasury went below 2% for the first time ever. Strange days indeed.

According to Credit Suisse, a recession occurs, on average, 22 months following such an inversion. However, I don’t see flat or inverted yield curves as foolproof predictors of a recession, and there are a lot of positive things happening in this economy.

Sure, protracted uncertainty about trade is having a real impact on business sentiment, but an argument can be made that we have lived with trade uncertainty for almost two years with only minor economic impact. The US economy is holding up well, and now it benefits from a more dovish Fed.

The US economy continues to create jobs at a robust clip, even with the unemployment rate already at a 50-year low. Employees' wages and salaries grew at 4.7% in 2017, 5% in 2018 and 5.1% in the first half of this year.[i] Household consumption powers the economy, and the household saving rate as of June this year is at a very healthy 8.1%.[ii]

China has shown a bit of weakness, but the latest data show that China's lower exports to the United States have been offset by stronger exports to the rest of the world. The weakness in Europe is more pronounced, notably in Germany as we saw this week with their recent gross domestic product data, but it’s quite a stretch to call it a collapse at this point.

Therefore, absent clearer signs of a long-lasting deterioration in macro fundamentals, we believe investors can still make money being long risk-on assets in the current market environment. The unknowns bear close watch, but we expect newfound visibility on the key matters we've been discussing all summer: Brexit, trade, and more populist shocks in elections.

The Fed has cut interest rates and signaled the possibility of further reductions, and the European Central Bank has opened the door to a resumption of quantitative easing. I think anybody buying a bond these days has to basically ignore the economic data to bet on lower yields, whereas I'm more inclined to bet that the inverted yield curve is just a good predictor of the Fed's intentions as opposed to a perfect predictor of recession.

Consequently, we would emphasize:

· Pro-risk asset classes—emerging markets may be well-positioned for a comeback

· A focus on risk allocation over capital allocation, leading to a strategic commitment to alternative investments

· Income in both public and private markets, which may help build an additional buffer against short-term volatility.

[i] Source: US Bureau of Economic Analysis.

[ii] Ibid

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