By Fergal Smith
TORONTO (Reuters) - Investors trying to work out whether the inversion of the U.S. yield curve signals a looming recession may find clues - but little comfort - in the Canadian bond market, which is less distorted by central bank buying.
The U.S. curve inverted last week for the first time in more than a decade as the 10-year yield dropped below the rate on the 3-month T-bill.
While inversion of the curve has preceded every U.S. recession for the last 50 years, its significance this time has been dismissed by some market participants. They argue that the curve has been distorted after the Federal Reserve bought trillions of dollars of bonds to help lower long-term rates after the global financial crisis.
Canada, where the yield curve also inverted last week, could be an alternative guide, even though its economy is one-tenth the size of the United States.
Canada does not issue as many long-dated bonds as the U.S. Treasury, leaving that part of the curve to the provinces. While its market has not been directly impacted by central bank purchases, its economy is so closely tied to its southern neighbor that it rarely enters a recession without a U.S. contraction.
Correlations between Canadian and U.S. bonds are high, at more than 90 percent, according to Refinitiv Eikon data. That tight relationship would likely weaken if the U.S. market were unable to overcome distortions to provide a signal on economic prospects.
"I see both inversions as true warning shots that the bond market sees a recession within the next few quarters," said Patrick O'Toole, vice president, global fixed-income at CIBC Asset Management. "Canada's signal is clearer than in the U.S." because the Bank of Canada has not meddled in the market.
Canada, a major oil producer that sends about 75 percent of its exports to the United States, has had five recessions - at least two consecutive quarters of contraction - in the last 50 years. With the exception of 2015, when the price of oil collapsed, the recessions were accompanied by a U.S. downturn. (GRAPHIC: Canada, U.S. past recessions, click https://tmsnrt.rs/2HLuIeO)
Although the 2015 recession was not preceded by an inverted curve, the prior contraction, in 2008-09 during the global financial crisis, was.
The worry now is that Canada's economy will falter due to trade tensions that slow global growth or due to record high levels of household debt.
Canadian yields trade as much as 98 basis points below U.S. yields, while money markets have shifted this month from expecting further interest rate hikes from the Bank of Canada to seeing about a 75 percent chance of a cut by December. The central bank has tightened its benchmark rate by 125 basis points since July 2017 to a level of 1.75 percent.
"There's no way they were going to be able to raise rates without crushing households," said Christian Lawrence, senior market strategist at Rabobank. "I fully expect the curve to invert further."
An inverted curve has not always led to a recession in Canada. Still, it does tighten financial conditions by reducing the incentive for banks to lend and the motivation for investors to take on the long-term projects that tend to boost economic growth.
"People are pooh-poohing the inversion, but if the inversion lasts or gets worse, that tightening could weigh on growth and in and of itself become self-fulfilling," said Tom O'Gorman, director of fixed income at Franklin Bissett Investment Management. "I would always be careful about thinking the bond market has it wrong."