Yield curve inversion: What next?

The party may not be over yet, but the markets globally are entering a dangerous phase

Over the last couple of weeks there has been much news chatter and gnashing of teeth over yield curve inversions in the US bond markets. Towards the end of March, various curves started inverting and then for a few days in April the all-important 10-year and 2-year curve also inverted. While this yield curve is now once again in positive territory, at just 19 basis points it can invert at any time.

Why is the yield curve important and what signals does it send? Why have global investment banks been falling over themselves producing research on inversions and its consequences? How important is this for the markets?

The two points that seem to matter the most are the 10-year to two-year curve and the 10-year to 3 months curve. These are the two signals most closely tracked by the markets, and the reason for all the nervousness as the first of these two critical signals inverted at the start of April. An inverted yield curve is taken by most investors to signify an upcoming recession and a policy mistake by the Fed.

The importance can be traced to the fact that every single recession in the US in the last 70 years has only happened after the 2s/10s has inverted. Financial history would suggest that we should be on heightened recession alert as the odds have significantly increased of a recession in the US hitting within the next 12-24 months, with the average lag being about 18 months. There is a dichotomy, however, at the moment. While every point from two years to 10 years has either inverted or is very flat, any curve involving three months' money is still very steep. There is a record divergence between any curve involving three-month money and longer dated instruments. The only explanation for the above is that the Fed is hugely behind the curve and that, as it rapidly raises rates, this divergence will narrow. The current Fed policy with the real Fed funds rate at (-) 7.6 per cent is the most loose it has been on this indicator in the last 75 years. It is inevitable that short-term rates will rise quickly and aggressively.

If forced to choose, most analysts seem to prefer the 2s/10s curve rather than the three month 10s, as while the former has inverted prior to every recession in the US, the latter curve did not invert and predict the pre-1960s recessions. As an indicator it is also a far stronger signal if any curve were to invert for at least three months, rather than just a brief inversion, which could be a head-fake. Once the curve inverts for three months, then within 12-18 months the recession does usually arrive.

Usually it takes about 24 months from the start of a Fed hiking cycle to an inversion of 2s/10s, with the curve continuously flattening as the hiking cycle begins. This is the classic cycle, Fed tightens, curve flattens and then inverts and then we get a recession. This time, it has taken only about three weeks from the first rate hike for the curve to invert, extraordinary compression and front loading!

If we look at asset class performance following an inversion of the 2s/10s curve, there is a variation across markets. Equities tend to do fine, and we have seen reams of research produced by various investment banks highlighting exactly this point. Why worry when the historical evidence seems to show that even 12, 18 or 24 months after an inversion, the S&P500 in the US has kept rising? What this data does not highlight is the discrepancy in the numbers post-1980 (source: DB). Pre-1980, an inversion in the 2s/10s curve would invariably cause a market correction, with the markets down in double digits 12-18 months after the inversion. Post-1980, the pattern changed, with equities up almost 20 per cent, 18-24 months later. If we are going to continue to follow the 1980s script, then equity investors in the US have nothing to worry about, but how long will this structural bull phase last?

Fixed income markets have always tightened, with credit spreads rising following an inversion. On average, credit spreads have widened by 40-50 basis points within 18 months. It is not surprising that every company is now trying to refinance or term out its debt. Corporate treasurers see the writing on the wall. As credit spreads widen, access for weaker borrowers will also become more difficult.

Illustration: Binay Sinha

While the yield curve has worked well in the US, it does not seem to have the same level of predictive power for the global markets. Across Europe, there are multiple instances of curve inversion leading to false signals and no recession. The signal is not tracked as closely in these markets.

While investors and analysts are hyper focused on the 2s/10s curve, the Fed has made out a case for using an alternative indicator to assess recession risk. The Fed has talked of using the 18 months forward three-month rate (18m/3m)- three-month yield curve. They believe this indicator gives a much clearer read of monetary policy expectations and is not clouded by multiple competing forces (term premium, inflation expectations, neutral rate) impacting the 10-year yield. The divergence between the favoured Fed indicator and the market favourite 2s/10s has never been higher. Ironically, the Fed indicator has never been steeper and shows very little probability of an imminent recession. Just for context, economists at DB calculate that the recession probability implied by the 2s/10s curve is almost 70 per cent in the US over the coming 24 months, compared to a 30 per cent probability signalled by the Fed’s preferred indicator. While the Fed may have its favourite, markets still react more to the classic yield curve given their familiarity and length of data.

While there will be noises from both commentators and policy-makers that this time is different, if the 2s/10s curve does invert and remain so for three months, then we must take it seriously. The reality remains that the Fed is way behind the curve and is now partly acknowledging this. It will tighten aggressively and rapidly. Every single Fed president has made it a point to lay out their discomfort with and prioritisation of inflation. To bring inflation under control, the real Fed funds rate will have to move into positive territory from deeply negative today. Financial conditions will tighten and hit the economy, animal spirits and consumer demand. A slowing economy, which is highly leveraged and faces tightening financial conditions, is always dangerous. The economy can hit stall speed quickly and its resilience to any external shocks will be non-existent.
 

We are entering a dangerous phase for the US economy and markets. There may still be a phase of sector rotation and higher markets ahead. Growth stocks could weaken and investors may move into value. That is possible. However, we must accept that the yield curve inversion, if it remains for 90 days, signals that the party is probably close to ending. If US markets go into a significant decline, equity markets globally will struggle, at least initially, till differentiation sets in and the fundamentals prevail again.

The writer is with Amansa Capital