Wives tales and Murphy’s Law persist for a reason. There are “market laws” as well. Old axioms that have persisted through time largely because of a good track record and predictive ability.
One of these market laws is that an inverse yield curve is a precursor to a recession. It worked with the United States pre-Great Recession and some are saying the fact that we have an inverse yield curve now in Australia signals a dire economic future for the country.
An inverse yield curve is exactly as it says – the line slopes down and to the right ( instead of the usual time value of money induced upward to the right) as you move along the time axis. So rates are lower the longer the maturity. Things must be looking bad for this to occur – I explain further below.
Now, of course, I’m on record here if saying back in May that this economy is starting to feel like it did prior to the recession we had to have back in the 1990.
It is fair to say though that after last quarter’s GDP I look more like a feather duster than a rooster – but my feeling about the long term impact of the twin headwinds of household de-leveraging and a high Australian dollar remain undiminished. Although I concede that I’m out on a limb here given mining remains strong.
I could argue, however, that this limb is heavily populated by market participants, traders and fund managers, based in the shape of the sovereign yield curve as you can see in the chart below:
Getting back to why an inverse curve says collectively that bad economic times are ahead, what is important to understand here is that traders have to be convinced that the economy is weakening and that more rate cuts are coming before they take longer interest rate instruments below the cash rate.
The reason for this is the cost of carry. That is, the treasury desk of a bank or trading house will usually be charging the traders the cash rate as its cost of funds, but for the trader to buy a bond that yielding 2.6%, 90bps below the cash rate, s/he has to believe that economic weakening will be sufficiently fast and deep that the capital return on the bond will outweigh the loss on yield.
Now, punters could be buying bonds to hold for a few days or weeks and then flick and make a capital gain that more than covers the cost of carry. But not everyone is doing this otherwise the yield will simply rise as buyers retreat from the market as no one wants to hold below the cash rate or cost of carry.
So, on the face of it, it looks like the market is suggesting that the RBA is going to have to cut rates substantially and that the chances of a recession are high in the next year or so.
My limb is not so lonely after all – or is it?
I’d argue that the chart above is the wrong way to evaluate if the market is expecting a recession in Australia. Rather, I would say that in a world of sovereign debt rubbish, Australia stands out as quality. Add the scarcity of Australian bonds relative to demand from offshore and there is a disconnect between what the curve is saying about the future path of the economy and the actual economy. The Australian sovereign bond curve is being pushed artificially lower by the simple dynamics of supply and demand – not entirely unrelated to our economic performance but probably more related to its relative strength than its weakness.
I think we can see a better indication of what the market is thinking if we look at the bank curve. Here I am talking about the bank bill curve at the short end and the swaps curve longer out. Certainly there is an element of credit in this curve, bank credit versus sovereign credit, but to the extent that Australian major bank CDS has rallied in the past month, I’d argue this won’t impact on our analysis:
In the chart above the sovereign curve is once again the blue curve with a low of 2.6% at the 3 year maturity while the combined bank bill and swap curve (in green) has a low in one year and at a rate just 25 points below the current cash rate (I will leave aside the distortive impact of bonds being semi and swaps out to 3 years being quarterly – but you get the picture).
When I look at the bill swap curve I do not see a recession call. I see a curve that certainly expects the RBA to cut again – 80 basis points over the next 12 months – but I do not see a recession call with the low point only one year out before rates start to rise again. This suggests that the market still believes monetary policy is and will be effective in Australia.
So after all of that, I’m still out on a limb with the recession and in truth it’s one of those calls that I hope is wrong. Perhaps monetary policy will still work effectively even in this de-leveraging environment after all.
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Please remember these are not recommendations for you to trade these are my views and I have my risk management tools and risk parameters that you do not have access to. Thus, this blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.