"Is this time different"? Yield curve inversion belongs to recession.

Inflation and the Yield Curve

Overview: January brought an unexpected turn as inflation reaccelerated, followed by a sharper-than-anticipated decline in retail sales. This has set in motion a fascinating phenomenon within the yield curve, with the 6M-2YR section steepening, signaling a sentiment of "higher for longer," while the 2YR-10YR segment further inverts, hinting at potential slowdowns in growth and inflation.

Why It Matters: The yield curve, a graphical representation of interest rates on US government bonds with different maturities, is a vital economic indicator. Its shape provides insights into current borrowing conditions and the market's future expectations for growth and inflation. A positively sloped curve typically indicates steady economic growth, while an inverted one suggests the opposite.

Historical Perspective: The inverted yield curve has been a reliable harbinger of recessions since the 1950s, earning its place as Wall Street's favorite recession predictor. Credit for this insight goes to Cam Harvey, a professor at Duke University. Despite experiencing its sharpest inversion in over 40 years, the yield curve has defied expectations, entering a phase of "bear steepening" in Q3 2023, showcasing the unexpected resilience of the US economy.

Is This Time Different? A significant divergence between monetary and fiscal policies is exerting uneven influences on various sectors, making it challenging for the Fed to implement rate cuts, especially as "core services" inflation remains elevated. The economic landscape is further complicated by escalating risks from corporate refinancing, potential debt defaults in commercial real estate, depleting reverse repos at the Fed, and rising consumer credit card debt. These factors collectively contribute to the downward pressure on longer-term yields, deepening the inversion of the yield curve.

Prophecies and Challenges: The prolonged maintenance of high-interest rates poses challenges for the Fed's attempt at a "soft landing," where the yield curve "bull steepens" without triggering a recession. The risk of self-fulfilling prophecies looms large, creating a complex scenario where economic dynamics interact with market expectations.

In conclusion, the interplay between inflation dynamics, consumer behavior, and the yield curve paints a complex economic portrait. As we navigate these uncertainties, a nuanced understanding of these intricate relationships is crucial for investors, policymakers, and market participants. The yield curve, once again, takes center stage in this unfolding economic drama, offering critical insights into the evolving economic landscape.

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Unraveling the Impact of Inflation and Retail Sales

Setting the Scene: The economic stage witnessed an unexpected turn as inflation surged in January. The Core Consumer Price Index (CPI) in the US exceeded expectations, rising by 0.4% month-on-month compared to the anticipated 0.3%. However, this isn't a cause for celebration. While durable and non-durable goods experienced deflation, the core services component, the stickiest part of the inflation basket, reaccelerated.

Goods Dynamics: During the pandemic, both durable and non-durable goods faced inflationary pressures due to supply chain constraints. As supply chains eased, these goods resumed their pre-pandemic deflationary trend. Notably, Shelter, representing 40% of the core CPI basket, still shows elevated inflation. The normalization of rent for primary residences, a slow process, is expected to bring a disinflationary impact to the overall Housing component in core CPI.

Fed's Dilemma: The Federal Reserve's battle against inflation hinges on the moderation of the "services excluding shelter" component of the CPI basket. Unfortunately, core services prices in the US, excluding shelter, surged from 0.2% to 0.9% month-on-month. This poses a challenge to the Fed's pursuit of declaring victory against inflation.

Retail Sales Stumble: Adding to the economic complexity, retail sales took an 0.8% plunge in January, surpassing expectations. This decline raises concerns about the resilience of the US consumer, given that consumer spending contributes to approximately 70% of US GDP.

Market Responses: The unexpected rise in inflation has prompted bond investors to recalibrate their expectations for the Fed's rate cuts in 2024. This adjustment is giving rise to a fascinating phenomenon in the yield curve. The 6M-2YR segment is steepening, indicating a sentiment of "higher for longer," while the 2YR-10YR segment is further inverting, signaling potential slowdowns in growth and inflation.

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Understanding the Basics: Let's delve into the fundamental concept of the yield curve—an indispensable tool in comprehending the dynamics of interest rates on US government bonds with varying maturity dates. For those familiar, feel free to jump ahead; for those seeking a quick refresher, you're in the right place.

The yield curve's shape unveils critical insights into prevailing borrowing conditions and the market's anticipation of future growth and inflation. A positive yield curve indicates that longer-term bonds yield more than their shorter counterparts. This scenario aligns with a flourishing economy, marked by growing yet controlled inflation. Investors, in this scenario, demand higher term premiums on longer-duration bonds as a shield against potential interest rate risks tied to time.

Conversely, an inverted yield curve unfolds when longer-term bonds yield less than shorter-term ones. This signals an economic slowdown and diminishing inflation. In such times, investors are content with lower term premiums, sensing reduced interest rate risk amid economic deceleration.

Factors at Play: Crucially, a bond yield's value (here, the US Treasury bond) mirrors the interplay of economic growth expectations, inflation forecasts, and term premiums. A positive yield curve, indicative of economic expansion, features elevated term premiums to counter growing inflation risks. Conversely, an inverted yield curve reflects expectations of economic slowdown, leading to diminished term premiums as both growth and inflation are anticipated to wane.

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The Yield Curve's Evolution: Recapping pivotal moments:

• Early 2021: From Feb-2021,The yield curve steepened on the back of optimism fueled by vaccine rollouts and substantial economic stimulus.
• 2022: Federal Reserve interest rate hikes flattened the curve, with investors welcoming lower returns on long-term debt as a measure to curb inflation.
• Late 2022-2023: The yield curve witnessed its most pronounced inversion since 1981, foretelling a potential recession.
• Late 2023 to Present: A resilient US economy, characterized by a robust labor market and moderated inflation, prompted a re-steepening of the yield curve. It's crucial to note that while the curve remains inverted, the depth of this inversion has diminished.

Looking Ahead: Terms like "bear steepening" and "bull flattening" have become commonplace, especially in discussions around the yield curve's impact on the stock market. These terms hold significant weight in deciphering the macroeconomic landscape. In the subsequent article, I will unravel these concepts in simple terms, providing clarity on their implications for the broader economic environment. Stay tuned for a deeper dive into the nuanced world of yield curve dynamics.

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Inverted Yield Curve and the Recessional Quandary

Setting the Stage: The inverted yield curve, a historical harbinger of economic downturns, has sparked debates about the likelihood of its ominous prophecy materializing this time around. Notably, the curve has recently experienced its most pronounced inversion in four decades, raising eyebrows. Yet, curiously, there's no recession on the immediate horizon.

Cam Harvey's Insightful Revelation: Cam Harvey, the luminary professor at Duke University and Director of Research at Research Affiliates, unveiled a pivotal revelation back in 1986. His groundbreaking insight suggested that an inverted yield curve had accurately foretold the seven recessions since 1950. The metric he introduced hinges on the yields of 3M Treasury bills surpassing those of the 10YR bond for three consecutive months, officially triggering an inversion and signaling an impending recession. Remarkably, this indicator boasts a flawless track record, anticipating each of the last eight recessions without any false alarms.

The Elusive Recession: However, as we entered Q3 2023, a fascinating phenomenon unfolded—the yield curve embarked on a "bear steepening" trajectory. Long-term rates surged at a pace outstripping short-term rates. This intriguing shift was propelled by an unexpectedly robust labor market, surging consumer confidence, and resilient consumer spending. Favorable liquidity conditions played a role too, as the government strategically issued shorter-duration debt, tapping into the excess liquidity parked in the Reverse Repo Facility at the Fed without unsettling bank reserves.

Contrasting Predictions and Evolving Sentiment: Adding another layer to the complexity, a Wall Street Journal survey of economists revealed a noteworthy evolution in recession predictions. The percentage of economists foreseeing a recession plummeted from 63% in October 2022 to a considerably more optimistic 39% in January 2024. This shift underscores the dynamic nature of economic forecasts, mirroring the changing landscape of factors influencing market sentiment.

But here’s the thing.

When the yield curve?“bear steepens”, longer-term yields rise and this has a large and rapid tightening effect on the real economy: 30-year mortgage rates rise, corporate borrowing rates climb across the curve causing financing to become tougher and negative mark-to-market effects are amplified?(hint: more pain for regional banks). This is why in all three previous instances?(September-November 2000, May-June 2007 and September-November 2018), rapid late-cycle bear steepening marked the end of the?“this time is different”?experiment and ended up causing severe distress to economies.

Plus, today, the Fed funds rate of 5.25-5.5% is significantly higher than the 6-month annualized Core PCE, meaning that the Fed’s monetary policy is restrictive at the moment with positive real rates. The last time,?“real rates”?(Fed funds rate- Core Inflation)?were this high was back in 2007.

At the same time, the tailwinds that were helping the US economy avoid a recession all this time,?are likely to turn headwinds?in 2024. Let me elaborate.

1. On the household front:?consumers that were once flush with cash have depleted their savings and increasingly tapped into credit card debt. With delinquencies on the rise and a labor market that is not as strong as it used to be, this will weigh down on consumer spending moving forward, like we saw with the decline in retail sales last week.?
2. On the corporate front:?While rising interest rates have been a boon to large corporations with strong balance sheets, smaller companies have not been so fortunate. 49% of the Russell 2000 universe is saddled with floating rate debt, vs. just 9% for the S&P 500. Small-cap companies also have a Net-debt to EBITDA ratio of 2.5, compared with 1.3 for the S&P 500. Finally, nearly half of the small cap universe is unprofitable. Add to the mix, the?ticking bomb of commercial real estate, there is a growing probability of real stress, if not distress, in the leveraged credit market.
3. On the liquidity front:?Up until now, the $2.5T of pent-up liquidity in the Fed’s Reverse Repo Facility played a pivotal role in absorbing new shorter-dated Treasury debt issuance, thus keeping bank reserves mostly intact. But what happens when the RRP barrel is empty?

Complicating matters further?(to a certain extent)?is the wider-than-normal divergence between loose fiscal policy?(which is stimulating)?and tight monetary policy?(which slows things down)?is contributing to wider-than-normal divergence between the performance of different economic sectors. In particular, it results in a wider-than-normal gap between sectors that are directly or indirectly on the receiving side of the deficits?(for example: businesses that rely on spending from upper and upper-middle class spenders)?vs. those that are the most sensitive to interest rates and thus are the most hurt by tight monetary policy?(for example: commercial real estate). Not convinced? Take a look at the image below.

And then ironically, because public debt levels are so high, tight monetary policy actually contributes to looser fiscal policy by increasing the overall interest expense of the government, which goes to various entities in the economy and strengthens some of the sectors that are not sensitive to interest rates.

In the week spanning from Feb-13 to Feb-17, 2024, the financial landscape witnessed significant movements in the 6M-2YR segment of the yield curve, characterized by a notable steepening of 14 basis points. This pronounced shift was instigated by an inflation print that surpassed expectations, subsequently prompting a recalibration of the anticipated timeline for the Federal Reserve's interest rate cuts along the curve.

Key Shifts in Market Sentiment:

• A month earlier, the market had factored in a 50% likelihood of the first interest rate cut occurring in March 2024. However, the current landscape paints a starkly different picture, with the probability plummeting to a mere 8.5%.
• Notably, the prospect of a rate cut in May has also seen a substantial reduction, dropping from a robust 83% a month ago to a more cautious 33% today.

Inversion in the 2YR-10YR Segment:

• Concurrently, the 2YR-10YR portion of the yield curve experienced a re-inversion of 5-basis points, transitioning from -29 b.p. to -0.34 b.p. This shift was triggered by lower-than-expected retail sales, hinting at a potential deceleration in consumer spending.

Remember:?the 2YR bond yields are very tied to short-term monetary policy decisions, so the Fed has a relatively strong control on that part of the curve. Meanwhile the 10YR bond yields can be thought of as the market-implied long term path for growth and inflation plus term premium.

Moving forward, the longer the divergence in monetary and fiscal policy keeps core services inflation from moderating at levels where the Fed declares a victory, the higher the chances of interest rates to remain where they are.

Last month, Cam Harvey?told Business Insider?that a recession is probable in 2024.

“The average lead time of inversions for the last four recessions has been 13 months, meaning a recession could be looming. Given the Fed’s actions of keeping rates too high for too long, I think the probability of a recession has greatly increased.”

Given the tightness of the financial conditions, I believe that we should start to see more weakness ahead in economic data prints, similar to what we saw with retail sales last week. This will once again cause the yield curve to invert further, squeezing financial conditions once again.

And by that time, if inflation has moderated per the Fed’s liking, the front-end of the yield curve will decline?(bull steepening)?indicating that the Fed cuts are on their way, leading to easier financial conditions. If the Fed is able to pull that off smoothly, without the US economy tipping into a recession, well then, this time will indeed be different. Else, the legacy of the prophecy continues.