The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of every recession in the past 40 years. No inversion yet so no recession worries. Convincing, right?
Without even starting into the statistical point about N = 5, I think we should unpack what an inverted curve is about and how likely it is to serve as a warning this time. Is it different this time?
An inverted yield curve means the 2 year yield is above the 10 year yield. Typically, investors want more yield for taking duration risk and locking up capital for longer periods of time. So most of the time, the 10 year yield is well above the 2 year yield. But when FOMC seeing inflation and a hot economy starts raising rates, and the short end follows. At some point smart money sees writing on the wall in stocks and want to lock in gains, demand for long term bonds increases, pushing yields down. So demand for safe havens after a period of rising short term rates is the real story in the inverted yield curve.
Mostly I agree with this. I track safe havens carefully and constantly factor them into analysis. Despite risk-parity machinations, in general I think strong safe haven moves tend to be bearish for stocks.
However, the elephant in the room is the massive global central bank QE programs in play since 2008 and crucially, their tapering and unwind. This creates a significant supply issue. We saw that in recent weeks - as ECB hinted at QE tapering, German and other EU bond yields jumped. This relieved pressure on US bond yields as well, with one of the biggest two week jumps of the year. This was nothing to do with safe haven demand or fundamentals - only the idea (not even the actuality yet) that a big force pushing yields down would start to relent.
In that environment, why should we expect to see an inverted yield curve ahead of the next recession? It really doesn't make any sense at all, and yet I have heard this phrase repeated several times in recent weeks from otherwise savvy commentators. Either I am missing something, or they aren't thinking this through.
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I don't have the math or economics training to properly sketch this out, but here goes:
Rising interest rates increase debt servicing
This is OK as long as income growth exceeds the cost of credit
Total debt + cost of servicing / Total income + income gains
Total debt * rate of change in cost of servicing / Total income * rate of change in income gains
The real issue is if debt costs go up faster than income gains, causing drivers of any economic engine attempting to not take on more debt, to slam on the brakes.
So we have a couple factors at play here - the increase on both sides (debt cost and income gains) and the magnitude and speed of each move.
The most benign environment for stocks is a slow and steady rise in rates, with an even healthier growth rate. This is not a problem at all.
The worst environment would a be rapidly rising increase in rates, with slowing growth in income. This will be a negative spiral. Basically, expenditures go up while income is not going up fast enough to cover the difference. The only choice here is to take on more debt - not optimal when debt costs are already increasing - or cut other costs. One assumes the party would seek more income if it could, and in a macro perspective, is already operating at maximum income.
If the spiral was bad enough - rising debt cost more than offsetting gains in income - why wouldn't resulting cutbacks and slowing growth lead to higher chance of recession? And in this scenario, would the 10 year yield be below the 2 year? Maybe not, especially if global central banks are ending QE and starting to unwind balance sheets. I think the market gets this, especially in the light of indexes holding up quite well in recent weeks with a flattening yield curve! If the market was concerned about inversion, should it not have retreated further when the curve was flattening? But it didn't!
Considering TNX went nowhere for 7 months, I don't think we are at scenario b quiet yet. At what level on the TNX, or steepening of the curve, be viewed negatively compared to global income gains? I don't know, which is why I just rely on pivots and technicals to show me the trends.
Just thought this was an interesting item to consider given I have seen the "yield curve inverts before a recession" several times in recent weeks.