Should we be afraid of the inversion of the yield curve? A brief passage of the US 2-year rate above the 10-year rate was enough to sow panic on the markets, Wednesday August 14th. And to trigger yet another attack by Donald Trump on the Fed which he says has done nothing to prevent this "CRAZY INVERTED YIELD CURVE!" (capitalized in the tweet).

If investors take the upheaval in the yield hierarchy so seriously, it is because historically, this signal has generally been a leading indicator of recession. The last five times that the 10-year rate fell below the 2-year rate - 1978, 1980, 1989, 2000 and 2006 - a period of at least two consecutive quarters of contraction in activity followed. In other words, a good portion of investors now consider that the countdown to the next recession has begun.

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So certainly, the debate on the reliability of the leading indicator is not closed. The link between inversion and recession is not systematic. Moreover, it is not immediate: it often takes between six and twenty-four months for the recession to materialize. The US economy is doing "pretty well", also recalled James Bullard, the president of the Fed of Saint Louis. As for Janet Yellen, chair of the Fed from 2014 to 2018, she considered that the inversion of the yield curve probably delivered a less reliable signal than in the past. "There are a number of factors other than interest rate expectations that are pushing long-term yields lower," she said.

However, if market operators are panicking, it is because they anticipate a slowdown in growth. Not directly from the American economy, but, unprecedentedly, indirectly, via the slowdown in global growth. Trade war, European slump, Chinese slowdown… The bad news is piling up. Three weeks ago, the IMF raised its growth forecast for the United States from 2.3% to 2.6% for 2019, but lowered it for the global economy from 3.3% to 3.2%. “The collapse of US rates mainly reflects the realization that the United States is not an island. The global economy is more interconnected than ever and bond markets are increasingly correlated,” wrote Societe Generale strategist Kit Juckes in a note earlier this week.

Contamination

Thus, the negative German and Japanese rates are contaminating the American market. In a world where $16 trillion in assets are serving negative rates, investors - often forced for regulatory reasons to hold government bonds - are flocking to the few remaining pockets of positive yield. Long-term Canadian, Australian, New Zealand and especially American government bonds are popular.

RBC Capital Markets economists have calculated that the yield on Treasuries (all maturities combined) is now on average 175 basis points higher than that of other government bonds in the world. A pay differential more than three times greater than the 53 basis points recorded on average since 2009. In this environment, the US 30-year T-Bond could still break some record lows. It fell below 1.94% on August 15 in session. The US 10-year rate hit 1.51%. For JP Morgan, it will fall to 0 by 2021.

To note

European rates are sinking a little further into negative territory every day. The French 10-year rate fell to -0.44%, the German 10-year rate to -0.71%.