The recent dip of the US five-year Treasury yield below the two-year rate has reignited fears of an overall curve inversion, which is usually seen as a precursor for an economic downturn. But while, according to research by the Federal Reserve Bank of San Francisco, “every US recession in the past 60 years was preceded by a negative term spread”, the actual timing is much harder to predict. Historical evidence suggests it can take anywhere between six months and two years from when long Treasury yields drop below short-term interest rates for GDP growth to turn negative.
Our research of central banks’ rate-raising cycles showed that share prices can even continue to rise for another year, as they did, for instance, after the US curve inversion in 2006. It then took a further six months before the recession set in. Yet, even as the overall stock market pursues its upward trajectory, defensive sectors can already start to outperform their cyclical counterparts — although this pattern has been more apparent in Europe than on the other side of the Atlantic.
A more consistent picture could be observed for corporate bond risk premia. Irrespective of the region and time period, credit spreads started to widen once long-term sovereign yields began their descent. This was also one of the most persistent correlation patterns we have witnessed throughout the recent Fed cycle, which began shortly after the US presidential election in 2016.
Another regular motif was an inverse relationship between share prices and corporate yield premia, with the latter tightening as the former rose and vice versa. However, as equity values continue to climb, while government bonds profit from lower yields during the later part of the raising cycle, the negative interaction of rates and spreads appears to prevail.
Since the Fed and the Bank of England have started to raise rates again, we have frequently noted a positive impact on their respective currencies. This happened not only at the actual rate rise date, but in anticipation of the move — for example, when a stronger-than-expected inflation release fuelled expectations of a more aggressive monetary policy response. The British pound, in particular, appeared to have frequently profited from higher short-term rates in past raising cycles, although more recent exchange-rate movements have been largely driven by the perceived progress of the Brexit negotiations.
The relationship between interest and exchange rates was less clear-cut for the euro and US dollar. As the world’s two biggest reserve currencies, their values are driven by a multitude of factors in addition to the interest rate differential. For example, the greenback regularly depreciated against its major rivals — euro and yen, in particular — in times of rising geopolitical uncertainty, such as a deterioration in the relationships with China or Russia. Conversely, the euro dropped against the dollar whenever the political situation worsened in Italy, Germany or France.
The euro has the additional particularity that it is shared by 19 countries. While issues relating to the UK are usually directly reflected in the value of the pound, the customary “release valve” for eurozone member states is the sovereign yield spread over German Bunds. The intensity of the reaction will further depend on the perceived safety and creditworthiness of the issuer. For example, the Italian BTP-Bund spread surged 150 basis points after the formation of the populist government in May 2018. In contrast, the risk premium on French 10-year OATs has gained only 8bp since the start of the gilets jaunes protests on November 17.
In general, contagion across issuers within the currency bloc has been fairly limited. A stress test we performed on a significant further expansion of Italian yield spreads resulted in only moderate losses for other peripheral issuers. As of yet, traders still seem to distinguish between countries with high debt-to-GDP ratios, such as Italy (132 per cent), Portugal (123 per cent) and Greece (180 per cent), and those with levels below 100 per cent, such as Spain (97 per cent). But there is an increased risk of wider sovereign spreads once the European Central Bank removes support for European bond markets by terminating its asset-purchasing programme in January 2019.
The BoE’s next steps will much depend on how (and if) Britain will leave the EU. Monetary Policy Committee members have already hinted that rates may rise faster than currently expected in the case of a favourable Brexit deal and an orderly transition period. In a hard Brexit scenario, on the other hand, it seems unlikely the Bank would actually tighten monetary conditions — especially in light of its “emergency” cut following the 2016 referendum result.
Christoph Schon is executive director, Applied Research, Axioma