The yield curve could be wrong


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Hello. Warren Buffett bought a big conglomerate in cash on Monday. Berkshire Hathaway is having a moment, and it looks like Buffett is keen to keep the momentum going. Bond markets are also dynamic – in the wrong direction. More on that below. Email us: [email protected] and [email protected].

The yield curve scares everyone

Last week, Ethan wrote that the horrendous performance of US Treasuries was something of an inevitable return to normalcy after they were placed in a politically-induced economic coma during Covid:

Across the curve, Treasury yields are returning to pre-pandemic levels, albeit in spurts. Even the bullish 30-year yield is back to where it was at the start of 2019. . . Epic fiscal, monetary and epidemiological interventions transformed the US economy overnight. A bear market in Treasuries mostly represents the return to normalcy, although high inflation and the war in Russia have made the ride more bumpy.

That remains true, but the ride has only gotten rockier in recent days. As the FT’s markets team reported on Monday, Treasuries had their worst month since 2016. Federal Reserve Chairman Jay Powell exacerbated the selloff with a hawkish speech, in which he left open the possibility of a rate increase of 50 basis points in the coming years. month. All the same: the 10-year yield is no longer where it was in mid-2019. Welcome everyone.

The concern is that the return to normal at the same time as the Fed engages in a fight against inflation could trigger a recession. In any case, this is the concern aroused by the yield curve. Powell’s speech sparked a spirited 18 basis point rally in the two-year Treasury; the 10-year rose by less than half; leaving the difference between the two at a paltry 19 bps. This left everyone staring gloomily at a painting like this:

The blue line, the 10-year/2-year curve, is heading straight for zero. Over the past 40 years, each time this has happened, a recession has followed (as shown in the shaded portions of the chart). In fact, it’s worse than that: Inverted 10/2 curves have preceded the last eight recessions and 10 of the last 13 recessions, according to Bank of America.

Why? David Kelly, chief strategist at JPMorgan Asset Management, sums it up succinctly:

An inverted yield curve doesn’t do much for the economy, but it’s a very bad sign. The only reason you would buy a long-term bond at a lower yield than a short-term bond was if you thought yields were going to fall. . . this usually happens when most people think the Fed has gone too far or will go too far.

This is the classic “Fed error”. Kelly describes the current case of a Fed error in terms of historically low unemployment. The economy must slow down somewhat in the not too distant future, because with an unemployment rate of 3.8%, “we have no more workers”. “It’s hard to produce more when there’s no one to produce it,” he says. This could happen just as the US central bank pushes rates to their peak, exaggerating the slowdown to the point of recession.

The Fed therefore risks causing a recession and having to rush to correct its error. John Higgins of Capital Economics explains what the deviated policy model looks like:

In the past, the 10-year yield itself has fallen significantly after the 10-year/2-year and 10-year/3-month spreads fell to zero or below . . . this coincided with a “bullish steepening” of the curve, as the Fed subsequently eased policy to counter the onset of an economic slowdown.

But the Fed’s easing comes too late, the markets are the first affected and the economy follows. Here’s Bank of America technical analyst Stephen Suttmeier on how it plays out:

Although time frames vary and can be long, the typical pattern is that the 2s/10s yield curve inverts, the S&P 500 peaks sometime after the curve inverts, and the US economy enters a recession six seven months after the S&P 500 peak. . . Post-reversal lows and last gasping rallies for the S&P 500. . . often occur before deeper recession-related market corrections.

Markets can do very well in and around curve inversions, as this excellent chart of sector performance from Ryan Grabinski of Strategas highlights:

Technical tracks are heading for a reversal. Classic defensives such as utilities, healthcare and consumer staples do well thereafter as investors brace for what is to come. But remember: when the recession finally hits, it’s just horrible. Suttmeier calculates that during the average recession, the S&P 500 falls by a third over 13 months – enough to make anyone think twice about hanging on to that latest bounce after the curve inverts.

This is all pretty bleak and explains why, if the 10/2 reverses, people will freak out a bit. There are a few visible rays of sunshine though, if you’re willing to squint a bit.

That first ray is the 10-year/3-month curve, which interest rate nerds like to point out has greater recession-predicting power than the 10/2 curve. Powell referenced it in his speech on Monday. Here it is, quoted by Bloomberg speaking to the National Association for Business Economics:

There’s some good research done by the staff of the Federal Reserve system that really says to look at the short – the first 18 months – of the yield curve. This is really what has 100% of the explanatory power of the yield curve. It makes sense. Because if it’s reversed, that means the Fed is going to cut, which means the economy is weak.

Looking at the 10/3 month curve in the first chart above, you will notice that it is not nearly inverted (here is part of the research Powell is referring to), a very different message from 10/2. Capital Economics compares the probability of recession predicted by the 2/10 and 3/10 months, using a model similar to the one the Fed itself uses:

So even if the 10/2 reverses, maybe we can dodge the recessive bullet? Ethan Harris of Bank of America’s economics team argues that we can. He thinks what the yield curve tells us has changed over the years.

Harris points out that long bond yields are made up of two parts: the sum of projected short-term rates, and then a premium on top of the sum, to compensate investors who lock in their money. But this last part, the “term premium”, has been squeezed out of the market by central bank quantitative easing:

The 10-year term premium has averaged around 1.5% in the post-war period. Therefore, in the past, it took a very tight Fed and strong fears of recession to trigger an inversion of the yield curve. Specifically, the market had to expect the future funds rate to average 150 basis points below the current funds rate to reverse. The Fed only cuts this in a recession. No wonder the inversion is a good predictor of recessions.

Today, the long end of the US yield curve is heavily distorted. The Fed deliberately pushed the long end of the yield curve lower with its asset purchase program. At the same time, very low bond yields outside the US are putting downward pressure on US yields. The result is that the term premium has now fallen into negative territory. The yield curve may now invert even if the market does not expect any rate cut from the Fed.

Here is the Harris table of the term premium. The change has been dramatic:

It seems perfectly logical to me. But to say that arguments like Powell and Harris are greeted cynically by the crusty old folks on Wall Street is an understatement. As our friend Ed Al-Hussainy from Columbia Threadneedle said:

Each time the 10/2 curve inverts, market participants come up with a long list of reasons why the slope of the curve tells us little about the current environment and should not correlate with a recession. We all know what happens next.

For about half a century, what happens next is a recession.

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