Gerard Fitzpatrick, Russell Investments global head of fixed income, isn’t worried about the yield curve.
Not yet.
But Fitzpatrick has a clear vision for when investors should take note of any ‘yield curve inversion’ – the infamous warp in normality where long-term US interest rates dip below short-term yields.
“If we see a yield curve inversion of 20 basis points [bps] for 20 days then that’s a very strong warning to investors that a recession is ahead,” he said.
The yield curve, typically taken as the10-year versus three-month US government bond rates, bent slightly out of shape earlier in 2019, inverting 4 bps for seven days.
Russell data shows the last three major yield curve inversions in 1989, 2000 and 2007 ranged in duration from 84 to 314 days while averaging 14-46 bps out of historical alignment: recessions followed all three events.
However, a milder inversion of 6 bps for five days in 1998 proved to be a false alarm.
Fitzpatrick, in NZ last week visiting local clients, said the brief blip below in 2019 also “looks likely to be a bond market mispricing” rather than a serious harbinger of recession.
In fact, barring any further curveballs, Russell is generally optimistic about the short-term global economic outlook, even to the extent of taking an contra-peer view on US rate hikes.
Since US Federal Reserve chair, Jerome Powell, put further rate rises on hold this year (after raising four times in 2018), the consensus expectation is for the next move to be down, Fitzpatrick said.
“We see there’s more probability of a rise later this year given we expect US wage inflation to come through,” he said.
For now, persistent low US inflation data remains a strong argument to prolong the so-called ‘Powell pause’, but the influence of two other factors on the Fed’s holding pattern has waned recently.
While the global economy is sending “mixed signals” – including the positive impact of Chinese stimulus countered by weak European data – Fitzpatrick said some of the current sticking points, such as trade tensions, were likely to be resolved this year.
And financial conditions have bounced back to a pre Powell pause par with equity markets erasing late 2018 losses and global central banks easing rates.
The recent rate cut by the Reserve Bank of NZ, for example, was “not too surprising” in light of the Fed signaling,” he said.
“There’s a certain amount of peer pressure among central banks: they don’t want to do the opposite of everybody else,” Fitzpatrick said. “But it’s also sensible to be in synch with the Fed.”
He said while the low-low central bank rates don’t leave much of a buffer if there is a correction, there was still enough in the monetary tank to hose down a minor crisis.
“It depends on the level of stress,” Fitzpatrick said. “We’re pretty optimistic that even if there is a recession it won’t be super deep.”
Likewise, income investors needed to look through the nominal low interest rates on offer to focus on after-inflation returns from bonds.
“Inflation is low, too, so there are still real returns available,” he said.
Bonds also retained their historical power to balance portfolios during a major correction in risk assets, Fitzpatrick said.
But after a post-GFC decade of bumper returns from both equities and bonds, he said markets appeared to be at a cross-roads with many investors wondering “what’s next”.
According to Fitzpatrick, fixed income still holds “good risk premia” across many sectors including credit, sovereign and currency (with Russell including the latter asset in its global bond fund) for active investors.
At this stage of the cycle, he said taking an index approach to global fixed income was “reckless” given the shifting risk parameters.
“[With a passive fixed income] you’re exposing yourself to risks with no ability to adjust,” Fitzpatrick said.
If the yield curve takes another, more serious, dive, for instance, the benchmark might not offer much comfort for fixed income investors.
“We’re watching the curve closely,” Fitzpatrick said.
Russell manages about $3 billion on behalf of NZ investors in its global bond fund.