Bank of America: “We’ve Seen This Movie Before: It Ends With A Recession”
In a merciful transition from Wall Street’s endless daily discussions and more often than not- monologues – of why vol is record low, and why a financial cataclysm will ensue once vol finally surges, lately the main topic preoccupying financial strategists has been the yield curve’s ongoing collapse – with the 2s10s sliding and trading at levels last seen in April 2015, and with curve inversion predicted by BMO to take place as soon as March 2018. And, according to at least one other metric, the yield curve should already be some -25bps inverted. This is shown in the following chart from Bank of America which lays out the correlation between the US unemployment rate and the 2s10s curve, and which suggests that the latter should be 80 bps lower, or some 25 basis points in negative territory.
Here is some additional context from BofA’s head of securitization Chris Flanagan, who views “the recent sharp flattening of the yield curve, which has seen the 2y10y spread go from 80 bps to almost 50 bps since late October, as the natural course of events at this stage of the economic cycle. Unemployment is low, and probably headed lower, and the Fed is intent on raising rates to stave off future inflation; we’ve seen this movie before and it typically ends with a flat or inverted yield curve. Based on history (and gravity), we think the most likely path forward is that the 2y10y spread reaches zero or inverts sometime over the next year or so and that recession of some kind follows in 2020 or 2021. (Given that the curve has flattened 30 bps in just over a month, projecting an additional 50 bps flattening over the next year is not really too bold.) Of course, much can happen along the way to change that outcome, but for now that seems to us to be the most likely course of events to us.”
Here Flanagan openly disagrees with the BofA’s “house call” of a steepening yield curve, and explains why:
We note that flattening is not the house call: BofAML rates strategists believe the curve will steepen due to easier fiscal policy, higher deficits, and a higher inflation expectation and the Fed will require higher 5y-10y yields as a precondition to flattening or inverting the curve. We recognize that the flattening process has already taken longer than we expected a few years back, due to multiple dovish Fed hikes, and we acknowledge the potential for what we think would be steepening detours along the way. In our Year Ahead Outlook, we tried to be especially mindful of the fact that a year is a long time and a lot can happen along the way. This would be a good example. Nonetheless, the Fed’s recent intentness on tightening in the face of low inflation readings makes us believe the last 50 bps of flattening likely will be achieved over the course of 2018.
Flanagan asks if a flattening curve is “a serious (grave) present day problem?” While it is true that a yield curve flattening and inversion always precedes a recession, the timing remains in flux. As a result, BofA notes that based on the history of the late 1990s and the 2005-2007 period, when the curve previously flattened into the 50 bps area, “we think it could be as long as 2+ years from now before spreads begin to meaningfully widen, which means 2020. In the meantime, again with history as a guide, we think securitized products spreads can continue to grind tighter. In other words, we are unlikely to see meaningful spread widening until recession actually arrives or is imminent. The recent sharp curve flattening is certainly noteworthy, but, in our view, it is way too early to start positioning for meaningful spread widening. The bull run in credit spreads has not yet ended and probably will last longer than many might expect.”
Finally, for some timing context, BofA shows the following chart of GDP growth vs the yield curve: the curve hit zero by the end of 2005 and inverted in 2006; economic growth steadily slowed in 2006 and 2007 but it wasn’t until 2008 that the downturn accelerated. Credit spreads widened and began anticipating the downturn in mid-2007, after the curve had been flat for over a year.