An interesting feature of investor behaviour is how we interpret and extrapolate themes from outside of the asset classes where we normally focus. 
Bond investors seeking to explain yield changes might look to equity earnings, and stock investors might try to reconcile equity valuations with central bank policy forecasts. Markets are, of course, inextricably linked and stability ultimately relies upon some sort of equilibrium holding across asset classes, which in turn relies upon information asymmetry between asset classes being kept to a minimum. It is therefore, in equal measure, ironic and necessary that we often try to rationalise unexplained moves in one asset class by first looking at others. Nevertheless, just as we would rigorously scrutinise asset markets with which we’re most familiar, we should be careful in blithely applying accepted “rules of thumb” from other asset classes.
As yield curves around the world flattened over the last few years, warnings of flat curves foretelling economic problems increased proportionally. Over the long run, there is good evidence of the predictive power of the yield curve, especially for the US; indeed we’d go as far as to say that when the US yield curve is inverted, it provides a meaningful de-risking signal. However, an inverted yield curve and a flattening yield curve are two very different things; moreover, non-US yield curves have significant local nuance – particularly the UK gilt curve.
Since the early 1960s, an inversion in the US yield curve – measured as US 10-year yields less cash or Fed Funds rates – preceded all seven recessions. There were two false positives: one in 1966, as fiscal tightening a couple of years earlier pushed the US into a mid-cycle slowdown, and another in 1998 around the time of the Asian financial crisis. With this kind of hit rate, it is little wonder that investors watch yield curves closely – especially when they are flattening.
History suggests that while an inverted US yield curve is a signal for caution, a flattening yield curve is not. In the nine phases of US curve flattening since the early 1960s the S&P 500 returned, on average, over 30 per cent from when the curve began flattening up to the point that it first inverted. But from the point of the curve first inverting to the point of maximum inversion, S&P 500 returns were on average -2.5 per cent.
Indeed, a curve flattening is a natural by-product of a rate hiking cycle and is common in the later stages of the business cycle. So while we do closely watch the yield curve, we think it is rather too early to call time on the expansion.
The UK gilt curve shows some similarities to the US curve with inversions tending to precede recessions, but there are more false positives plus a period from the early 1990s to the mid-2000s where the cash versus 10-year curve was on average more than 100 basis points flatter than the US curve. Most of this difference is accounted for by policy rates, the real UK base rate (i.e. adjusted for inflation) was on average 130 basis points higher than the US real Fed Funds rate throughout this period. Differences in the structure of the mortgage market at the time are often cited as a reason for the structurally flatter UK curve over this period.
With base rates in the UK just 0.5 per cent but the US six hikes – and counting – into their hiking cycle, this front effect is no longer a feature. Nevertheless, there are still local market nuances to consider in calibrating the predictive power of the UK curve. The first is that around a quarter of the outstanding stock of gilts is held by the Bank of England, and this is unlikely to change until well into a UK hiking cycle. Secondly, the structure of the UK pensions market, with the meaningful proportion of defined benefit obligations plus significant regulatory incentives to hold long dated index-linked gilts, presents a powerful bloc of demand at the long end of the UK curve. The net result is that even with UK base rates still exceptionally low, the gilt curve is quite flat, and even a modest rise in front end rates will cause further flattening.
For an investor with significant UK asset exposure, there are three key messages. First, the yield curve is a powerful indicator, but it is an inverted curve rather than a flattening curve that provides a signal. Secondly, even for an investor with no US assets, it is an inversion of the US yield curve rather than the local curve that matters most. And finally, while a flat or inverted UK gilt curve has some signalling capacity, there are local factors which point to a structurally flatter UK curve throughout the cycle.
John Bilton is head of global multi-asset strategy at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.