When yield curves flatten, it can raise alarm bells about whether there is a recession on the way. There's certainly been plenty to cause worries in recent months. Bank of Singapore does not yet think the time for alarm is at hand.

The US government bond market yield curve is starting to flatten – sometimes taken as a red flag about impending recessions – but investors shouldn’t brace themselves for a downturn just yet, Bank of Singapore said in a note yesterday. 

Yields on short-dated maturities such as three-month and one-year notes continue sloping upwards, but the line on a chart flattens off between five- and 10-year parts of the maturity curve. In the past, a flattening curve has pointed to a possible contraction. When short-term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall.

Source: worldgovernmentbonds.com

Investors have much to be jittery about: high US and other countries’ inflation numbers, rising energy costs, a possible Russian invasion of Ukraine and the blockages and disruptions to supply chains stemming from COVID-19. 

But Bank of Singapore reckons alarm about recession is not yet fully justified.

“While these uncertainties could result in near-term economic headwinds and further market volatility, we do not see an impending inversion of the yield curve or a recession, especially if we consider that quantitative tightening by the Fed is expected to keep yields at [the] longer end of the curve supported,” the Singapore-based private bank, part of OCBC, said in a note.

Since 2021, when inflation data began rising significantly over central banks' targets, investors have started to wonder when, not if, rates will rise, and what effect this will have on their asset allocation policy. For the last decade and more, interest rates have been very low by historical standards, encouraging a big shift into higher-yielding, if less liquid, assets such as private equity, credit and property.

Worries
In the US, official figures showed that inflation came in at 7.5 per cent year-on-year, topping the approximate 40-year high of 7.0 per cent recorded for the month of December. The US Federal Reserve has signalled that it expects to start putting up interest rates and draining some of the huge sums of money that had been injected into the system via quantitative easing. The Bank of England also recently hiked interest rates, and voting figures showed that rate-setters narrowly avoided putting rates up even more. In the eurozone, the European Central Bank has warned that inflation risks are on the upside. A major debate is about whether inflation is a temporary state stemming from the disruptions caused by the pandemic, or something more enduring.

Bank of Singapore noted that the US consumer price figures, taken together, “presented evidence that the inflation trajectory could be less benign for the whole of 2022 and crucially significantly different from the Fed’s previous assumptions, which could drive a shift to an even more hawkish stance at the next FOMC meeting in March.”

US bond yields rose sharply late last week, producing some of the flattening of the curve as referenced above. Such moves also brought a fall in equities last Friday.

Eurozone, China plays
The US is likely to push up rates ahead of the eurozone, but the overall move towards higher rates should be positive for the euro, BoS said in its note. Some euro upside, however, will be contained by worries about Ukraine, the bank said.

Bank of Singapore, which said it preferred to hold Asia ex-Japan equities, thinks the risk-reward calculation looks increasingly positive for Chinese equity markets. China is loosening its monetary policy and lifting some of the restrictions on the economy – in selected areas, the bank said.

“In addition to the [China] rate cuts, Chinese policy makers are also easing financial conditions via a number of administrative changes. Regulators have announced that they plan to expand the `registration-based’ IPO system used in China’s smaller venture board to the main board this year. This is expected to give more freedom to issuers and promote much-needed equity financing for companies in China, freeing up resources for the credit crunch in the corporate sector,” the bank continued.

BoS said that it expects a reversal of some restrictive policies on the key real estate sector, as authorities seek to prevent episodes such as the default of Evergrande and other developers becoming more serious. 

“Last week, the People’s Bank of China and China Banking and Insurance Regulatory Commission announced that affordable rental housing loans will be excluded from banks’ real estate loan concentration management limits,” BoS said.