• As UST yield declines, yield is showing inverting curve

• An inverted yield curve is a good predictor of US recession

• The last 2 US recessions brought KLCI values down by average 40%

US yield curve – what it means for equities

In April and May 2018, we wrote about the US yield curve giving yellow alert to the economy. As the 10-year yield was rising, the yield curve flattened, as the spread between the 10-year and 2-year was only 0.5% then. There was also a discussion that a risk of US recession happening if the Fed over-estimates economy and tries to counteract growth emanating from tax reform and government spending, and then becomes too aggressive on rate hikes. We believe that was the current concern then, coupled with economy entering its 9th year of expansion.

As we are heading towards end-2018, and more than 6 months on, a lot of has happened, and change, in the US – the markets, rates expectations, trade tariffs/war – and the emerging economy space.

The latest issue currently is on the US yield inverting. With 10-year UST rates coming off its peak the past few weeks, (including the 5-year) short term rates, primarily the 2-year US treasuries have stayed resilient. The spread between the 10-year and 2-year is currently at just above 0.1% (versus 0.5% discussed above in April/May).

Basically, the yield curve compares interest rates at different maturities. Typically the spread between UST yields on 2-yr and 10-yr maturities are looked at to determine the yield curve, whether it is inverting, flattening or steepening. The 10-year UST yield historically has reflected the market’s growth and inflation outlook, while the short-end of the curve is mainly tied to market’s expectations for Federal Reserve policy rates.

Simply put, the yield curve is typically the steepest after recessions (short term rates are lowered stimulate activities, refer yellow circles in chart 2) and would invert when a recession is approaching (refer red circles Chart 2). Over the course of business cycle, yield curve tends to be flat as short term yields rise as Fed raises rates to keep inflation in check.

Observation from previous US recessions in 2000 and 2008

Between Jan 1998 and Jan 2000 yield spread was primarily below 0.5%. It fell to a low of -0.5% in Apr 2000. During this period, i.e. between Jan 1998-Apr 2000, the US S&P500 rose by 46%. In the 2008-09 recession, yield spread fell below 0.5% in May 2005, then stayed primarily negative between Feb 2006 until June 2007. During this period, i.e. between May 2005-June 2007, the S&P500 rose by 28%.

Three observations in the previous 2 recessions.

• Yield inverted approx. 1-2 yrs before the recessions took place;

• S&P500 rose as spread fell below 0.5% about halfway through economic expansion. Unlike current boom, where spread fell is now below 0.5% after about 10 years of expansion as interest rates were low due to QE; and

• S&P 500 peaked 6-12 months before US enters recession.

The key question is: has the US stock markets peaked if we take the above observations and assume that the US will enter a recession in 2H2019? Judging from the above scenario, it appears to be the case at the moment.

It is difficult for Malaysia to insulate itself from a US recession, as shown in the past. Already Malaysia’s GDP growth for 2018 and 2019 has been tempered to about 4.8- 4.9% for these 2 years – and our guess is the risk of lower growth for 2019 is about 5-060% if US-China conflict continues to drag, despite the 90 day reprieve as not much is expected from this truce.

During the previous US market sell-off caused by recession, the KLCI drifted lower by an average 45% over a period of approximately 18 months from its peak. The KLCI previously peaked at 1,896 in April 2018. At this point, if a recession is several months away as predicted by the yield curve, the KLCI is at risk of losing more ground in the coming months.

Source: BIMB Securities Research - 6 Dec 2018