Markets could be in panic mode by late next year if the flattening yield curve turns into a full-on inversion, but it won’t turn into a massive sell-off, the head of asset allocation at UBS Asset Management told CNBC.
The yield curve, which shows the gap between the interest rate on the two-year Treasury note and the rate on the 10-year U.S. bond, is interpreted by several investors as an indicator of an upcoming recession. As the gap between both yields narrows and the curve flattens, the more the market believes there will be economic turmoil.
This becomes a more worrying phenomenon when the yield on the 2-year note becomes higher than the one on the 10-year paper — a phenomenon described as an inversion of the yield curve. This is because it indicates that markets see a higher risk of borrowing money for the short term than at the long term. In a growing and healthy economy, lending at the longer term should be seen as a riskier because it is harder to predict what’s going to happen.
The yield curve indicator has caught the attention of investors over the last few weeks given that the line has become flatter. Erin Browne, head of asset allocation at UBS Asset Management, told CNBC last week that the indicator will continue to flatten and invert in late 2019 — causing major stress among market players, who will be wondering whether or not a recession is about to kick in.
"I expect that the U.S. yield curve will continue to flatten and will invert in late 2019. While I expect volatility around the inversion event to pick up, I don’t think investors should take inversion as a sign of an impending recession,” Browne told CNBC via email.
“The absolute level of rates is very low, and thus an inversion will have less of an impact on financial conditions than in the past,” Browne said.
Interest rates have fallen to record low levels in the wake of the sovereign debt crisis to prop up the economy. Only now, about seven years down the line, central banks have started to assess and implement some rate hikes. However, the expectations are that rates will be moving gradually and thus remain low for some time. According to Browne, because rates are low, an inversion of the curve won’t bring a huge impact to the markets.
"We do not expect a massive sell off from yield curve inversion. While there will be volatility around the event, the practical implication of inversion should not induce a significant sell off given the low absolute level of yields relative to growth,” she added.
Morgan Stanley also argued in a note earlier this month that it forecasts the yield curve will invert by the middle of 2019.