Economic history has demonstrated that cycles dictate the pace of business life and that all growth phases must come to an end. The length of the current cycle in the US has alerted analysts, many of whom are now watching closely for any signs potentially indicating its end. In this respect, the yield curve, which is a favourite topic among analysts, is considered as a useful predictive gauge for shifts in the economic cycle. Anticipations among market professionals reflected in the shape of the yield curve can trigger comments either predicting the threat of inflation or a likely recession.
The ongoing flattening of the curve in the US since early 2013 has therefore been of great interest. Although the election of Donald Trump in 2016 slowed the process, the curve has continued to flatten since the beginning of 2017. The recent fall in long term yields has even almost caused an inversion on certain segments of the curve. The spread between 10-year government bond rates and 3-month Treasury yields has turned negative. The US Federal Reserve central bank, as illustrated in several studies, is clearly highly preoccupied.
For investors, who need to decide how to allocate their assets, this is an important issue. Should we anticipate a shift in policy by the monetary authorities? In this case, should we shift weightings towards equities or bonds? Should we modify allocations within asset classes?
To answer these questions, it may be of use to understand the sequence of historic performances among different assets in the wake of this type of event, notably with regard to Fed decisions.
Let us firstly observe that over the past 40 years, inversions in the US Treasury yield curve (10-year / 3-month) have been followed by recessions (pink bars).
As well as identifying recessions, Fed decisions and above all their effects on bond and equity performances are of key interest for investors.
The Fed has systematically cut its rates within the 6 to 13-month period after the event, i.e. almost simultaneously with the economy tipping into recession.
There is no clear trend in 10-year yields in the wake of the first inversion signal. On the other hand, after the Fed intervenes, 10-year yields tend to fall further.
There is no clear trend after yield curve inversion either. However, US equities have tended to fall (at least initially) following the first Fed rate cut.
With regard to these events, inversion provides few clear signals for asset allocators.
However, a focus on the first move by the Fed following inversion implies adopting a more prudent approach to equities and cautious confidence for bonds. We shall therefore be all the more attentive to the next comments from Fed Chair Jerome Powell.