Bond market battles itself on whether inversion means recession

Bond investors are locking horns over whether the inversion of yield curves really means the global economy is headed for recession.

For some, its predictive record speaks for itself. The last five times the yield on 10-year Treasuries dropped below those on 2-year securities, a contraction followed. For others, the bond market is now so distorted that an inversion isn't the kiss of death it used to be, though it may still become a self-fulfilling prophecy.

"The reality is the bond market smells trouble and equities are just starting to catch on," said Charles Diebel, head of fixed income at money manager Mediolanum. "Based on the yield curve, there's an 80% chance of the recession."

Determining whether or not a recession is coming by next year is crucial for fund managers looking at where to put their cash. The bond market has never been so expensive, with about $16 trillion of investment-grade debt now having negative yields — guaranteeing a loss for investors if held to maturity.

The flipping of the yield curve in the U.S. and the U.K. Wednesday triggered turmoil on Wall Street, with the S&P 500 Index slumping 2.9% and the Dow Jones industrial average plunging 800 points. President Donald Trump once again lashed out at the Federal Reserve for having interest rates too high, describing the yield curve as "CRAZY INVERTED."

The inverted yield curve looks set to be a global phenomenon, with Japan and other major Asian debt markets primed to mirror the moves in Treasuries. The Reserve Bank of Australia's Deputy Gov. Guy Debelle weighed into the debate Thursday, downplaying the inversion in the Treasury curve, saying he wasn't sure "how useful that signal is."

"If there were to be a recession, it's not clear at all what the policy response would be," Philipp Hildebrand, vice chairman at BlackRock Inc., told Bloomberg Television. "The problem of being out of ammunition adds an additional concern to markets and is an additional explanation why we're seeing these extreme movements in the yield curve and in interest rates generally."

UBS Global Wealth Management and Morgan Stanley Investment Management are among those betting the U.S. economy will dodge recession for now, so long as the Fed helps to steepen the curve by cutting interest rates. For the former, that means it is too early to sell equities, while emerging-market currencies such as the Indonesian rupiah and South African rand still offer investors a positive return.

"Bond yields signal recession risk, we say not so fast," wrote Mark Haefele, chief investment officer at UBS Wealth Management. "If Fed rate cuts successfully steepen the curve comfortably into positive territory, this brief curve inversion may be a premature recession signal."

Others take solace from the bond market being in a new era. Central banks have pumped trillions of dollars into the global economy, artificially pressing down the long end of the yield curve. At the same time, the risk of an inflationary spurt has also diminished, making it safer for investors to take refuge further out the yield curve. In Europe, there have been growing calls that Europe is now suffering from so-called "Japanification," where yields, inflation and growth stay low, but that does not mean recession.

"The market is more inclined to question those who argue 'this time is different,'" wrote analysts at Commerzbank including head of rate strategy Christoph Rieger. "With term premia also at record negative levels, the recession signal may be questioned."

For Peter Chatwell, head of European rates strategy at Mizuho International, it may not even matter who is right at this point. The inversion gives consumers and businesses a powerful signal that a recession could be on its way, causing them to rein in spending and investment, which could accidentally trigger one anyway. The RBA's Mr. Debelle also warned of a "self-fulfilling downturn."

The inversion is "very powerful once it reaches the popular press," said Mr. Chatwell, who is continuing to recommend investors hold onto long-duration positions. "If the Fed was to stay behind the curve, then the market would bring forward recession expectations, allowing long term rates to rally further."