The outlook for the UK economy and stock market is poor. This is one inference to draw from the fact that 10-year gilt yields are close to record lows.
I say this because what’s true of the US is also true here: the slope of the yield curve predicts economic activity and equity returns, with flatter or inverted curves leading to lower growth and worse returns.
Since 1987, inverted curves (in the sense of 10-year yields being below three-month interbank rates) have led on average to the All-Share index rising only 2.1 per cent in the following 12 months. Upward-sloping curves, by contrast, have led to average rises of 5.7 per cent. And inverted curves have led to manufacturing output falling by 0.6 per cent on average in the following 12 months while upward-sloping ones have led to average growth of 0.9 per cent. These facts are consistent with research by Charles Goodhart, a former member of the Bank of England's monetary policy committee (MPC), and colleagues who show that inverted curves have predicted recessions for most of the time since 1822.
You might think these numbers aren’t too troubling, given that the yield curve is still upward-sloping. Not so. Flatter curves also predict slower growth and lower equity returns. Since 1987, three-month rates and 10-year yields have both helped to predict annual changes in manufacturing output and the All-Share index. Higher short rates and lower long yields lead to lower growth and returns, while lower short rates and higher long yields lead to higher growth and returns. For the All-Share index, this is true even if we control for US yields and the Fed funds rate or for the dividend yield. If these relationships continue to hold, they point to manufacturing output falling 0.8 per cent in the next 12 months and the All-Share index rising only 0.5 per cent.
There’s a simple reason why this should be. To see it, remember that gilt yields should in theory be equal to the average of expected short rates over the maturity of the gilt so the 10-year yield should be equal to the expected return on a one-year bond reinvested nine times. Low yields, therefore, are a sign that investors expect short rates to be low on average. A big reason why they might expect this is that they expect the economy to be weak in the near term. Such expectations are often right, so low gilt yields lead to falling output and low equity returns.
If all this sounds gloomy, there is a huge caveat here. Although these relationships are statistically significant, they are not very strong. Three-month rates and 10-year yields explain less than one-fifth of the subsequent variation in manufacturing output growth and only one-16th of the subsequent variation in equity returns. The yield curve has given us a wrong message many times. Inverted curves in 1992, 1998 and 2004, for example, all led to nice rises in share prices. And upward-sloping curves in 1993, 2002 and 2015 all led to shares falling.
What’s more, the dividend yield is still above its long-term average. This is sending a stronger buy signal than the yield curve’s sell signal.
You might think this means that gilt investors just get it wrong sometimes. Maybe, but there are two other reasons why a flat or inverted yield curve might not predict bad times. For one thing, low gilt yields might be due not to investors fearing recession as a central scenario, but merely to them taking out more insurance against the small possibility of bad times. And for another, yields are driven by things other than purely interest rate expectations. Pension funds, for example, need long-dated gilts to match their future liabilities, while insurance companies need medium-dated ones to match theirs. If these liabilities increase, their extra buying can drive gilt yields down, independently of the near-term economic outlook. Indeed, strong demand from such sources is generally thought to be one reason why the UK’s yield curve has traditionally been flatter than the US’s.
So yes, low gilt yields are sending us a signal to be wary of equities and the economy. But the signal is a weak and noisy one. It’s a case for slightly shifting our mental dial towards cautiousness rather than a good reason to sell.
