Yield Curve

Given the beginning of an easing cycle in September and the Trump Trade in October, the lack of steepening in the yield curve is intriguing. While tighter financial conditions are likely a challenge to the steepening move, policy regimes and the term premium are favorable toward further curve steepening.

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The 10Y-2Y yield curve broke above the key level of -0.4% and that means a double-bottom pattern is in play. While we are confident that a major steepening cycle is here, we have to acknowledge that the nascent move could fail. A steepening move is also the market’s way of signaling easier conditions ahead.

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We studied market behavior around yield curve re-steepening and identified six historical cases. Of those, three were successful and preceded major recessions. The other three instances failed and reversed to new lows. The gist of the study: We are at a critical crossroads.

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Given the tendency of economists and strategists to dismiss the message of an inverted yield curve, it’s surprising there’s been no scrutiny of the “dog that didn’t bark”—the inversion of 1966. That’s the last time an inverted curve did not lead to a recession.

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Frequently, there’s money to be made in the stock market in the months following the initial curve inversion. After the inversions of August 2006 and June 2019, the S&P 500 rallied another 23% and 19%, respectively, into its final bull market high. If this cycle plays out in textbook fashion, the business-cycle peak would arrive in September.

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Market veterans know there’s just one thing more probable than a recession after the yield curve inverts: Yield curve denial among a large group of sell-side economists and market strategists! Indeed, the earliest of those dismissals occurred last March—a month before the first of more than a dozen iterations of a yield curve inversion. 

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Last month’s inversion in the 10-Yr./3-Mo. Treasury spread further tilts an already lopsided scale in favor of a U.S. recession in 2023. That spread has been considered the gold standard from an economic forecasting perspective, and is the basis for the New York Fed’s Recession Probability estimate (which, by the way, should break above its critical 35% threshold when it’s published later this month.)

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The main yield curve drivers—fiscal and monetary policies—might be suggesting a steepening move is coming soon, while bank stock performance may also be hinting at a turn in the curve. However, a durable selloff in the U.S. dollar would be needed to support a steeper yield curve, so the tightening pain could last a while longer.

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We think the U.S. economy will slip into recession sometime in the next year, but the level of “excess savings” provided by pandemic aid renders the already difficult task of timing more elusive than ever.

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The scene in our neighborhood in the last two summers has become one of relaxed and well-tanned professionals out in their yards overseeing home improvement and landscaping projects. No surprise: Not a single one has told us they’re less productive when working from home!

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Yield curve action is getting harder to dismiss by the day. But which curve is the most relevant? We tried to answer that question in disciplined fashion in April. To our surprise, the “2s10s” spread that’s ubiquitous in bond-land scored near the bottom of the pack.

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Now that the yield curve has inverted, its dynamic is apt to change from bear flattening (higher rates, flatter curves) to bull steepening (lower rates, steeper curves) fairly soon.

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Key indicators are indeed trending in “pre-recessionary” fashion. Among them is the ISM New Orders Index, which dipped into contraction territory in June while inventories increased. Others are the JOLTS that shows a strong (but weakening) labor market, and unemployment claims—which have ticked up.

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In a simple test of 15 yield-curve variants, we found that the 2s10s spread ranks second to last, based on its correlation with one-year-forward real-GDP growth since 1978. The three best measures employed the 3-month bill as the “short” rate. The spread between the 5-year note and 3-month bill showed the strongest correlation with subsequent economic growth.

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Predicting a recession is a very tall task, let alone using a single yield-curve indicator with long and highly variable lead time. Instead, we would rather focus on some of the more reliable themes: The macro-policy setting; U.S. dollar; and Bank stocks.

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The U.S. 10/2-year curve just fell below the key threshold of 50 bps. Over the last 25 years, the yield curve proceeded to invert after this “Rubicon” was crossed. That doesn’t mean imminent trouble. The lead time of a yield-curve signal is lengthy, but it—and real yields—definitely warrant close monitoring.

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Last month, we published a table showing where we thought a variety of economic and financial-market measures lay along the economic recovery “continuum.” Although the upturn has officially entered just its 22nd month, the bulk of those measures looked “late cycle” in nature.

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Last year’s consensus view that inflation would prove “transitory” missed the mark. There’s no reason for shame; inflation forecasting hadn’t been a required investment skill for the previous 30 years.

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Stimulus and soaring stock prices have contributed to the fastest consumer-confidence rebound of any economic recovery on record. Yet the manner in which this bounce has unfolded is anything but “early cycle.”
 

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We studied several “popular trades” and there are good reasons to be on board with most of them, but none can be viewed as a no-brainer.

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