Canada

Yield Curves: Canada’s Recession Indicator Is Now Flashing Red Alert

The recession indicator “that has a perfect record” in the US is now flashing red alert in Canada. Canada’s 10-2 treasury yield spread officially inverted in July. The spread has been flattening since 2017, but finally turned negative last month. The yield curve inversion indicates investor expectations for the future are spiraling lower. We know, none of that made sense to the average person. Don’t worry, here’s a plain english guide to why your portfolio manager is randomly sobbing.

Bonds and Yield Curves

First, here’s a quick refresher (or intro) to bonds and yield curves, for those that need one. Bonds are a way for issuers to raise money, for a predetermined set of time. In exchange for the cash, issuers give regular payments over the term – called coupons. Bond yields, in its simplest form, are the annual total of the coupons, as a percentage of the face value. The rest, i.e. the face value, is returned at the end of the duration. The general rule is, the higher the return, the more risk is assumed. Longer terms usually have greater risk, since the future is less clear the further out you go.

The yield curve is a plot of bond yields from an issuer, usually a government, by length of time to maturity. A healthy yield curve slopes higher as it moves further to the right of the graph. That is, the longer the bond offer, the higher the yield should be. Under normal circumstances, a 10-year Government of Canada bond pays more than a 2-year. It’s not easy to know what will happen in two years, but it’s usually easier to guess than 10-years out.

Example Yield Curve

An example of a typical “healthy” yield curve, with yields rising as term lengths increase.

Source: Better Dwelling.

An unhealthy yield curve slopes lower as it moves further right on the graph. As longer term rates begin to drop, the yield curve “flattens,” as risk piles on. If the curve slopes down, and longer-term bonds return less than near-term, there’s a problem. Investors are demonstrating they believe the future is less risky than today. This is an ominous sign, often indicative of a recession, and known as yield curve inversion. Now that you’re on your way to being the next Bill Gross, here’s what we’re looking at today.

The 10-2 Treasury Yield Spread

A common yield curve watched is the 10-2 (pronounced ten-two), from governments. This is the difference between the yield of a 10-year bond, and a 2-year bond from the same issuer. Ideally, when watching this you want to see a positive spread. Meaning the longer-term (10-year) is higher than the short-term (2-year). When the spread is negative, the 2-year is higher than the 10-year, we get yield curve inversion.

The 10-2 is common due to the distinct sensitivity and demand influence. 10-year treasuries are most influenced by investor expectations of the future. Since they’re long dated, they aren’t as volatile as shorter-terms. The 2-year more closely resembles the overnight rate. These shorter-term bonds tend to reflect the movements of consumer borrowing rates. So when the 2-year rises above the 10-year, investors have turned bearish – the consumer just has no idea. In plain english, investors are demonstrating they think borrowing to buy an asset near term means you’re probably overpaying for the asset.

Note, demonstrating is distinct from saying something. Often the words don’t align with the actions of an institution. Traders have a mantra that describes this, “trade what you see, not what you know.” The reason is, by the time someone tells you they see an issue, they’ve already prepared themselves. Otherwise, they risk losing liquidity, which impacts their profits.

Canada’s 10-2 Yield Curve Inversion

Canada’s yield curve inverted last month, for the first time since the Great Recession. The 10-year Government of Canada bond yield fell to 1.49% in July, a decline of just 1 bp from June. The 2-year Government of Canada bond jumped to 1.55%, rising 9 bps in a month. Canada hasn’t seen the spread fall this low in over 10 years, and even then it was only for a few months.

Canadian Yield Curve (10-2 Treasury Spread)

The spread between the 10 and 2-year Government of Canada benchmark bond yields, as reported monthly.

Source: Bank of Canada, Better Dwelling.

Canada’s 10-2 yield curve has inverted before, usually followed by recession. Going back to 1980, the 10-2 inverted in the early 1980s, from 1988 to 1990, mid-2000, and mid-2007.  It’s usually not a great sign of things to come. Each one of those followed with a technical recession, with one exception.

Canada’s 10-2 inverted in the year 2000, without a technical recession. GDP did not fall for two consecutive quarters shortly after inversion. Unemployment did rise 90bps, and nine interest rate cuts were made. One of the few reasons GDP didn’t print a recession was oil prices surged. In the year 2000, oil prices reached the highest levels since 1990, helping to bolster the GDP print. No technical recession was made, it just felt like one.

“Those who say things are different each time are probably counting on the fact that it will take about 2 years to know for sure, so who’s going to remember?”

Arturo Estrella, the economist that first noted the relation of yield curve inversion and recessions. 2019.

There’s some discussion that “this time is different.” Which is usually what’s said right before an issue boils up. After all, if they acknowledged the issue, they may be able to change the outcome. The fact that they aren’t, is typically what causes so much damage.

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23 Comments

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  • Ethan Wu 4 weeks ago

    Check your terminal this morning. Most recent print has the curve inverted at -0.19. Canada needs to BOOM to move higher from here.

    • Jin 3 weeks ago

      Yup, dollars marching higher against the loonie too.

      • Bluetheimpala 3 weeks ago

        USD is increasing vs most currencies. Can’t buy UST is unicorn farts. Can’t fight eurodollar and repo with out UST. I would argue our positive yields have created a bottom for our currency. Say 70 cents but it looks to be closer to 75. Or not. Off to buy some more AU stocks, balance yo shit playa. BD4L.

  • DB 4 weeks ago

    This means rates will go down, which will send prices higher.

    • Georgie 4 weeks ago

      Not even close to what it means. When long-term rates drop, investors stop lending out long term, and liquidity dries up. When liquidity dries, lenders look for higher quality borrowers who can actually prove they can continue to make the payments, even if their existing assets fall in value.

      This is why the BOC just launched another bond buying program. They’re expecting liquidity to dry, and they’re positioning for QE this time to help keep the minimum amount of liquidity.

      i.e. You don’t want to be in Canadian pesos when they start printing money so you can borrow.

      • Renter 4 weeks ago

        Great explanation. Thank you. Would the alternate lenders also keep looking for high quality borrowers?

        • Georgie 3 weeks ago

          There’s kind of myth that alternate lenders take in bad credit in the first place. They often take in people with good credit, but with more shaky income documentation. They do take some people with bad credit, but they need to provide sufficient assets in order to offset the risk. i.e. if they think home prices can drop 20%, they want much more than 20% to offset any risk in the event you don’t pay.

          There’s a good article on this site I recall reading awhile back, that went through US subprime lenders and showed during the peak, it wasn’t people with bad credit using them. It was actually people with good credit, and a home trying to speculate on second, third, fourth, and more homes. This was also the segment of people that ended up defaulting, not the poor people.

          This is my understanding, and hopefully someone from the mortgage industry can chime in. But basically alternative lenders aren’t lending to a lot of bad credit. They’re lending to overextended investors, that have secured more than the size of potential loss to offset and risk.

    • GB 4 weeks ago

      The Bank of Canada is set to cut rates next month… short term rates are too high in Canada… just look at European negative rates. And the US will do the same.

      • Trader Jim 3 weeks ago

        Yes, and with lower rates will come higher credit risk, and increased qualifications. If a 40bps increase in unemployment happens with debt levels, what do you think happens to the houses where they can’t afford to spend $200 more or risk bankruptcy?

    • Mtl_matt 3 weeks ago

      It means people will lose their job and default on loans they never could have paid back anyways, and banks will have an inventory of houses they’ll want to offload.

  • CanadaSucks 3 weeks ago

    Canada is not the US, Europe. Canada currency is not a reserve currency like US or Euro. What other nations are doing in term of interest rate might not be something that Canada can do. CAD is not a popular currency and Canada is not an attractive nation to invest into right now. What ever that BOC do expect the CAD devalue similar to what we saw in Australia and New Zealand not long ago. The only for the CAD to get stronger is for the US to devalute their dollar.

    • Trader Jim 3 weeks ago

      Small correction. It’s for the US to devalue their dollar faster than ours devalues. The US doesn’t have nearly as high of debt loads or housing costs though, so they don’t need nearly as much stimulus as we will to kick start the economy.

  • DB 3 weeks ago

    Hey ! there are two DB on this site ? why is that possible ?

  • Realist Generation Z'er 3 weeks ago

    This isn’t going to stop global investors from Hong Kong parking their monies into Canadian real estate as a safe haven/ Recession or not, Canada is deemed a parking lot for global capital, whether legal money or laundered money.

    A recession isn’t going to stop more 80 to 90 story tall Bloor Ones from popping up all over Toronto.

    • DB x5 3 weeks ago

      lol – and remaining 90% unsold – great example lol

      • K Money 3 weeks ago

        1 in 8 new homes absorbed in Toronto and 1 in 10 in Vancouver can’t be wrong! lol.

        I don’t think investors realize there’s two markets, the one they’re invited to and the one where agents get deep discounts to flip back to the market. Even some of the “hottest” projects aren’t doing price slashes yet, but offering tens of thousands in incentives to make it seem like prices are stable.

  • DB 3 weeks ago

    DB 4 here.

  • Trevor Stafford 3 weeks ago

    Meh? We’re in financial bizarro world now. So much ‘money’ has been created (and will be) that this may not be a reliable signal. I mean, there are LOTS of signals flashing, globally. Is this one? Who knows. The German situation worries me a lot more. Negative mortgages? Jesus. Brexit?

    The US 10-2 has inverted a few times in the past few weeks. The market dropped at first then shrugged. Everyone is banking on the Fed stoking the overheated DOW engine with lower rates just to keep the party going. And frankly the U.S. economy is still pre-recession….with signals.

    Rates will come down. Ours too. Amphetamines. Money will pour in from everywhere. Real estate party starts afresh.

    Waiting on a black swan.

    • Millennial Whinger 3 weeks ago

      Negative rates do not equal negative mortgages. Negative rates are for lenders, not borrowers. Lenders aren’t in the business of paying borrowers to borrow money.

      The real estate party is not going to ‘start afresh’. It’s going to stagnate as everything else catches up to the inflation of the housing market.

      Get ready for more world wide inflation than we have seen in 100 years. There’s nowhere to hide. Not gold, silver, or the ridiculous crypto systems will save from what is coming.

      Also, unless we are in a recession, we are always ‘pre-recession’. The problem with recessions is you never know when one is coming, just that one is. Everything is cyclical.

  • Rene 3 weeks ago

    If you are trying to sell a house in Canada right now, GIT ER DONE. If you are thinking of buying.. DON’T DO IT…!
    The bottom line is this, Canadians are well under water as a nation. Our housing market in 07/08 did not experience enough pain to compensate the market gods and they want their pound of flesh. They will get their pound that they’re owed, and a few more pounds interest in the next downturn. We are talking about an inter-generational event. The tsunami of inflation in consumer goods that was held at bay for so long through “inflation steering”, guiding that inflation into the stock, bond and real estate markets, that tsunami will pour over the food prices at your grocery store as those markets collapse. And in an effort to kill the market gods, the good ol’ USA will start a war.

    • Millennial Whinger 3 weeks ago

      I do agree with your comments regarding cost inflation of every day items.

      But if someone is looking at buying a house, and they are looking at staying there long term, it may be a good time to lock in a 10 year and ride it out. Don’t overspend, but also don’t listen to the fear crowd. You have to live somewhere, better your own place than renting from someone who may be financially insecure and therefore creating insecurity for you.

      • Nancy 3 weeks ago

        Yeah okay. Buy now when house prices are still 200K over what they should be rather than rent and ride out the storm. Wheres the logic in that?

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