Yield curve inversion, what it is and what it means

The yield curve is a snapshot continuum of yields on which bonds of increasing maturities are trading at a point in time.

Yields express the level of return that you and I require to hold a particular bond to its maturity.

When we are in a risk stable and growing economy, the curve shape is typically bottom left to top right, with higher yields increasing the further out you go to reward you for locking your money away for longer.

But sometimes it works in the inverse.

When you see investors demanding higher yields at the short end of the curve (say at the 2-year mark) versus the longer end (say at the 10-year mark), it means they are sensing more risk to growth or higher inflation in the short term versus the long-term.

When that happens, the curve changes shape. If the forces are strong enough, the curve pivots around the middle of the curve and transforms into a ‘top left to bottom right’ curve. That’s what yield curve inversion is.

When the curve remains inverted for a few months or more it can signal an upcoming recession, particularly when the 2-year treasury is higher than the 10-year.

U.S. treasury yield curve now inverted for >3 months

Today, the U.S. yield curve has been inverted (2-year yield > 10-year yield) for more than three consecutive months.

It’s shown clearly in the chart below.

While the mooning of the 6-month yield in July (brown line) is notable, the actual inversion of the 2-year over the 10-year did not occur until August 5, 2022, after the U.S. job market added 528,000 jobs.

It was that element of good news that (surprisingly) demonstrated a highly resilient job market and caused the secondary market to conclude that the Fed would raise interest rates in response.

And that’s what it did.

How did we get here?

Here’s the play book so far.

Ex-Fed chair Ben Bernanke did not normalise the Fed’s balance sheet nor interest rates after the exigent circumstances of the GFC were over by the beginning of 2010. Neither did Jerome Powell, although Janet Yellen tried. The QE Infinity train to nowhere gathered speed.
COVID struck, and lockdowns accelerated trillions in Fiscal stimulus (including treasury guaranteeing loans plus welfare fiscal and stimmys) and this super charged supply of Main Street chimney money and over-liquidity pushed risk asset prices higher, and bond yields lower.
Russia smashed into Ukraine and a combination of Russian withholding and responsive sanctions limited the global supply of oil, LNG, fertiliser and food, and consumer price inflation reappeared. Inflation jumped from assets to consumer prices - an inflationary slingshot and one that was already primed by the welfare in 2.
Since then, the Fed has been lifting the Federal Funds Rate (FFR) in an attempt to stamp out inflation and while initially the bond market ignored it, more recently it woke up and took notice. This led to curve inversion.
But to be clear, the QE Infinity train to nowhere is still hurtling along its tracks to who knows where, although every month it stops to let one or two passengers off (aka the balance sheet run-off) somewhere.

Now what?

After 3.5 months of inversion, the bond market is expressing a strong signal that the Fed has already gone too far with FFR hikes, and that these actions will tip the country into recession - a hard landing.

If Biden stays on his current course, Powell, the President’s DJ, is likely to continue tightening to carry out his bosses wishes (aka, the Fed is not independent).

Most likely, the Fed will continue to ignore the destruction in risk assets and the inflationary consequences of deglobalisation and continue to tighten for longer in an attempt to rein in inflation and deliver into the labour agenda. You can read about that here.

Under that scenario, the knock-on effects include: less liquidity, stronger USD and exported inflation, weaker commodity prices (ex-energy, EV minerals for a time, food), higher cost of capital, weaker risk asset prices, attractive money market yields, higher net interest margins for banks, greater pressure on other central banks to keep up with the Fed, higher default provisions for banks, lower aggregate demand globally, and trouble of zombie companies.

Is this the only potential outcome?

No, it’s not.

So then, what events might challenge that scenario?

If the U.S. job market weakens significantly and interest rate increases shrink in size and/or number, or the Fed capitulates and pauses (signalling a ‘pivot’). Currently, equities and to a lesser extent bond markets are sniffing (again) the beginnings of this.
If more bond markets untether and break like in Australia, Japan and the UK (forcing the Fed to pivot and/or extend more/higher swap lines to pullback Dollar Vader).
If the Republicans gain ground in the U.S. mid-terms next month (signalling a challenge to Biden’s fight against inflation) and Biden capitulates leading to a Powell pause or pivot.
If the ECB joins central banks in China, Japan and the UK in taking on more QE Infinity train passengers and paving the way for a Bretton Woods 2.0 moment.
If there is an end to zero-COVID in China, a China deleveraging, and/or a significant/rapid healing in global supply chains.
If an accord is reached in relation to Russia/Ukraine.

Recessions in the U.S. and Europe look likely in 2023. That said, the above points could be scenario spoilers and produce a different outcome, if one or more were to occur. Time will tell.

But right at the minute, miles away from Powell, what gives here in Perth?

Lithium is the word. Recession is not the word.

Predictions for a Fed pivot following one more 75 basis point FFR hike abound. In the event of an early pivot, we would see a weaker USD and stronger commodity prices and that would benefit WA based exporters.

There are also noises about a relaxation of zero-COVID. If that was to happen, commodity demand would strengthen.

If both of those were to occur at the same time, you would use the world boom, not recession.

While I believe we will eventually see a Powell pivot due to global debt levels and Dollar Vader, and while zero-COVID might eventually be relaxed in China, we are not there yet. Right at the minute, an inverted yield curve in the U.S. is one factor that suggests recession in the U.S., perhaps next year. If that happens, Europe goes as well. While this may not happen in WA per se, there will be some transmission through currency pairs and commodity volumes/prices as well as earnings downgrades as aggregate global demand takes a hit.

Acknowledging the scenarios that I have set out above can be instructive for how you might want to create some optionality in your business/investment strategies, particularly if they are overly reliant on China, certain challenged industries/assets, and/or sensitive to +/- 10% changes in the AUD/USD pair.

See you in the market.

Mike

Yield inversion continues for third month - what lies ahead?