INTRODUCTION

A portion of the US yield curve has inverted. While this is not the typical 3-month to 10-year inversion that presages a recession, markets are nevertheless on heightened alert. This piece will discuss the predictive power of an inverted yield curve and will show why we are not yet concerned that one will materialize.

RECENT DEVELOPMENTS

Parts of the U.S. yield curve have inverted. Yields at the belly of the curve have risen by more than the long end, enough so that the 3- and 5- to 10-year portions of the curve have inverted for the first time since 2006. That was at the same time that the more traditional 3-month to 10-year measure of inversion took place. At 12 bp, the 2- to 10-year curve is getting awfully close. What makes these move so strange is that the more widely watched 3-month to 10-year curve has steepened at the same time. At 193 bp currently, it’s the steepest since February 2017 and suggests recession fears may be overblown.

An inverted US yield curve has always been the market bogey-man. As we shall see below, full 3-month to 10-year inversion typically presages a recession in the following 12 months. While falling short of this more widely-followed inversion, we think that sustained inversion of some portions of the curve could eventually spook investors. For now, global equity markets appear content to follow the Fed’s guidance that it will engineer a soft landing. However, the situation continues to evolve. A fully inverted U.S. yield curve would surely test this market hypothesis.

Making things even more complicated is the divergence between the 3-month to 10-year and the 2- to 10-year curves. Typically, all three main measures of the yield curve move together. Yes, there have been brief periods of divergence. However, as the chart below shows, there has never been the sort of divergence we are seeing now between the 3-month to 10-year curve and the 2- to 10-year curve. Eventually, this divergence should ebb and is likely to come from a higher 3-month yield. At the same time, we believe the long end of the U.S. curve will move higher as QE ends, enough to prevent inversion from spreading. To us, the 3- and 5-to 10- year inversions seem to be more of a quirk from the flat yield curve than a precursor of something more ominous.

Market expectations for Fed tightening continue to intensify since the March 15-16 FOMC meeting. 50 bp hikes for May 4 and June 15 are both about 75% priced in. Looking ahead, the swaps market sees the policy rate at 2.75% over the next 12 months and peaking near 3.0% over the following 12 months. Despite the move higher in tightening expectations already seen, we believe the Fed Funds rate may have to move above 3% in order to properly cool inflation.

A BRIEF ECONOMICS LESSON

Beginning in the late 1980s, economists began to run empirical studies on the predictive power of the inverted yield curve. There are too many theoretical explanations for its predictive power to delve into in this piece. What matters is that it works quite well.

From a San Francisco Fed study dated March 2018: The predictive power of the term spread is immediately evident [from Figure 1], which shows the term spread calculated as the difference between ten-year and one-year Treasury yields from January 1955 to February 2018, together with shaded areas for officially designated recessions. Every recession over this period was preceded by an inversion of the yield curve, that is, an episode with a negative term spread. A simple rule of thumb that predicts a recession within two years when the term spread is negative has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession. The delay between the term spread turning negative and the beginning of a recession has ranged between 6 and 24 months.

Another piece by the San Francisco Fed from August 2018 suggests that the 3-month to 10-year spread has the strongest predictive power. Researchers found that “that the traditional 10y–3m spread is the most reliable predictor, and we do not find any evidence that would support discarding this long-standing benchmark as a measure of the shape of the yield curve. It is worth emphasizing again, however, that all of these term spreads are fairly accurate predictors and quite informative about future recession risk; the differences in forecasting accuracy are small.”

That said, the same authors warn: “Furthermore, when interpreting the yield curve evidence, one should keep in mind the adage “correlation is not causation.” Specifically, the predictive relationship of the term spread does not tell us much about the fundamental causes of recessions or even the direction of causation. On the one hand, yield curve inversions could cause future recessions because short-term rates are elevated and tight monetary policy is slowing down the economy. On the other hand, investors’ expectations of a future economic downturn could cause strong demand for safe, long-term Treasury bonds, pushing down long-term rates and thus causing an inversion of the yield curve. Historically, the causation may well have gone both ways. Great caution is therefore warranted in interpreting the predictive evidence.”

At this point, the 3-month to 10-year curve is the furthest from inversion since 2016. Inversion at the belly of the curve bears watching to see if inversion continues to move down the curve. At this point, we see nothing to suggest that a recession is becoming likely (see Economic Outlook below). If the full curve were to invert, then we would have to revisit this, to state the obvious.

ECONOMIC OUTLOOK

The limited curve inversion comes as the Fed embarks on an aggressive tightening cycle amidst heightened stagflation fears. By most measures, the economy is pretty much close to full employment. The March jobs report this Friday is expected to show 490k jobs gain and the unemployment rate to fall a tick to 3.7%, just a touch above the pre-pandemic low of 3.5%. With the labor market so tight and likely to get tighter, we firmly believe that wage pressures, already rising, will likely move higher. This in turn will filter through to already high generalized price pressures. It’s becoming clear that the Fed waited too long to tighten policy and is now engaged in playing some serious catch-up.

The million dollar question is whether the Fed can engineer a soft landing or not. The Atlanta Fed’s GDPNow model is tracking 0.9% SAAR growth in Q1, down from 1.0% previously. Sequentially speaking, growth will likely continue to slow from the 7.0% SAAR posted in Q4. For Q1, Bloomberg consensus sees growth of 1.5% SAAR, picking up to 3.3% SAAR in Q2 and 3.0% SAAR in Q3. For the full year, the Fed sees 2.8% growth followed by 2.2% next year. This is slightly below Bloomberg consensus of 3.5% and 2.3%, respectively.

We believe the Chicago Fed National Activity Index remains one of the best indicators to gauge rising U.S. recession risks. The 3-month average was 0.35 in February and has been in positive territory since June 2020, and well above the recessionary threshold of -0.7. Note that a value of zero shows an economy growing at trend. Positive values represent above trend growth, while negative values represent below trend growth. If this 3-month average were to dip into negative territory, it would sound the warning. If it were to fall below -0.5, then recession risks would be getting significant. Stay tuned.

INVESTMENT OUTLOOK

We acknowledge that curve inversion, if sustained and goes all the way to the 3-month to 10-year measure, will pose risks to the growth outlook. While recent Fed messaging suggests the U.S. economy is strong enough to withstand the tightening cycle, other exogenous shocks pose a risk that could tip the economy into recession. First and foremost is the aggressive tightening cycle. After that is the potential negative impact of an oil shock. As we shall see in a later piece, a large and sustained spike in energy prices poses risks not only to inflation but to growth, as we saw in the 1970s. With both coming at us at once, markets really need to pay close attention.

The impact of Quantitative Tightening (QT) is a bit of a wild card. Studies suggest long-term yields have been artificially depressed by years of Quantitative Easing (QE). Perhaps that is one reason why the long end of the U.S. curve has not risen as much as the belly has. With an announcement on QT likely at the May 3-4 meeting and possible implementation at the June 14-15, a major factor keeping long rates down will be removed. With inflationary pressures still strong, this argues for higher long-term U.S. rates and so we look for curve steepening to continue. The U.S. 10-year yield should rise to 3.0% and could eventually test the October 2018 high near 3.26%. Similarly, the 30-year yield should also rise above 3.0% and could eventually test the November 2018 high near 3.46%.

For now, U.S. rates continue to support the dollar. The U.S. 2-year yield has broken decisively above 2% in the wake of this month’s hawkish FOMC decision. It traded today near 2.40%, the highest since April 2019 and on its way to test the November 2019 high near 2.97%. The 2-year differentials with Germany, Japan, and the U.K. continue to make new multi-year lows. In particular, the Bank of Japan clearly showed that it is nowhere close to abandoning Yield Curve Control and removing accommodation. USD/JPY traded above 125 for the first time since August 2015 and is on track to test the June 2015 high near 125.85. After that, there are no significant chart points until the January 2002 high near 135.15. The euro remains heavy just below $1.10 and we still expect an eventual test of this month’s cycle low near $1.08. Sterling is trading heavy near $1.3140 after being unable to sustain a move above $1.32 last week. We look for an eventual test of this month’s new cycle low near $1.30 and then the November 2020 low near $1.2855.

Equity markets appear unfazed and continue to rally. The S&P 500 has recouped nearly two thirds of its drop this year and a clean break above 4550 would set up a test of the January 4 high near 4819. DJIA and NASDAQ are lagging a bit and have retraced nearly half of their respective drops. What this suggests to us is that the equity markets have faith that the Fed (and other major central banks) can achieve a soft landing. While that is also our base case, we acknowledge that the risks of a hard landing are not insignificant. With 250 bp of tightening priced in over the next 12 months and the growth outlook very much uncertain, equity markets would seem to be overvalued.

Of course, all of these investment recommendations are predicated on a continued economic expansion in the U.S. If the outlook worsens and the economy slows significantly, then the Fed will have no choice but to adjust its expected rate path. This would likely lead to a reversal of our recommended trades, with the dollar weakening, bond yields falling, and equity markets rallying. It’s worth noting that the yield curve inverted back in May 2019 and eventually led the Fed to undertake its so-called “mid-cycle correction.” Rates were cut a total of three times in succession on July 31, September 18, and October 30. The 3-month to 10-year curve turned positive again that October. It then inverted again in February 2020 just as the pandemic was spreading across the globe and the rest is history.