Reuters/Mike Blake

A yield-curve inversion, which occurred last week, often signals a recession is coming in the medium term.

But RBC's chief US economist, Tom Porcelli, argues that last week's yield-curve inversion is different.

He says asset bubbles are the real risk as the US economy outperforms the rest of the world.

The inversion of the yield curve, in which short-term Treasury yields exceed those of longer-term notes, has many market commentators claiming that a recession is near. Last Friday, the yield on three-month bills exceeded that of the 10-year note for the first time since 2007. The S&P 500 was off nearly 2% on the day, its worst performance since January 3.

The yield curve typically slopes upward, as longer-dated Treasury bonds typically have higher yields than shorter-term bonds. A flat curve means all bonds have the same interest rate, and an inverted curve means the curve slopes downward at some points, with longer-dated bonds at lower yields than shorter-dated ones.

Investors usually receive higher interest rates when they commit funds over longer time periods. When the opposite happens, as it does during a yield-curve inversion, many people take it as a warning signaling near-term unease.

An inversion of the yield curve has consistently and accurately forecast every recession in the US since the 1960s. The lead time, however, has ranged widely, from one to three years, with the stock market often logging double-digit returns before the onset of a recession.

Many market commentators have indeed taken last week's inversion to be a sign of a looming recession, with the Morgan Stanley equity strategist Michael Wilson telling investors they should "remain defensively positioned."

In contrast, Tom Porcelli, RBC's chief US economist, believes the risk associated with a yield-curve inversion is not a recession but an asset bubble. He argues that the latest inversion does not follow the historical pattern in which domestic investors drive down long-term rates over fears of short-term economic turbulence.

Instead, Porcelli says the long end of the curve has been driven by global growth fears while US economic growth remains relatively robust.

"The problem with the current inversion and the historical record is that the yield curve at present is not a referendum on the path of economic growth in the United States, but rather a function of goings on globally," Porcelli wrote.

"Yields have become more a function of global growth dynamics and indeed have become anchored to low/negative sovereign yields abroad. What this means is the United States is able to finance relatively good rates of growth at artificially suppressed interest rates."

Indeed, if this is the case, then a recession will not follow the inversion as many others forecast. Instead, a robust US economy will be further bolstered by low long-term rates driving increased activity in the housing sector and borrowing more generally, all of which could rekindle an asset bubble.

"So, no, we are not on recession watch because of this dynamic — we are, more than any other point this cycle, on bubble watch," Porcelli concludes.

RBC

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