What an Inverted Yield Curve Is Telling Us About a Potential Recession

This week, a violent selloff in bonds caused parts of the U.S. Treasury yield curve to invert. This is the term for a situation where a shorter-term bond actually has a higher yield than a longer-term bond. Historically, this has been an ominous sign. The yield curve has inverted shortly before every recession since 1980. The inversion that we saw this week is only the beginning. It is very likely the curve will become more inverted over the course of 2022. Therefore it would be good to explore what yield curve inversion does and does not mean, and what it says about recession risk in the coming quarters. Does an Inverted Curve Predict a Recession? First let's consider why the shape of the yield curve changes at different points in the cycle. In theory, the rate on any given bond should be equal to the average of future overnight rates. In other words, if the 2-Year Treasury yielded 2% but everyone knew the Fed was going to hike to 4% in the near-term, everyone would sell the 2-Year and buy overnight securities. Those sales would cause the 2-Year yield to rise, and that process would continue until investors were indifferent between the two options. With this in mind, let's consider why a curve inversion might predict a recession. Currently the 3-Year Treasury yield is higher than the 10-Year yield. Using the logic above, what that suggests is that the average Fed target over the next three years is expected to be higher than the same average over the next ten years. The only way this could be true is if markets expect a rate cut at some point. We can see this a bit more directly by looking at yields implied by futures markets. The chart below is the projected 3-month SOFR (Secured Overnight Financing Rate) based at future dates, which should closely track the Fed's target. You see this yield rises through mid-2023 but then falls in 2024 and 2025. Chart Source: Bloomberg So indeed, the market is projecting rate cuts in the future. Therefore the 10-Year yield should be lower than the 3-Year. Note that this doesn't suggest a recession necessarily, merely that the Fed is expected to ease at some point. That being said, we can also see why curve inversions tend to presage recessions, as the Fed is going to tend to be cutting during a period where the economy is slowing. What If the Fed Needs to Hike Beyond Neutral? Fed Chair Jerome Powell said in a speech this week that the Fed may hike beyond common measures of neutral to tame inflation. Right now markets seem to think that only a hike or two into restrictive territory will be enough. But what if it isn't? What if there needs to be a larger overshoot before inflation subsides? If this is the case, then expect the yield curve to become severely inverted. Longer-term bonds will be anchored around the neutral rate. Remember we said that all bond yields reflect the market's expectation for the average fed funds over that time horizon. Hence a 30-Year Treasury will only be minorly influenced by current Fed policy and mostly influenced by a view on where rates settle out in the long-run. So unless the market revises its view on what neutral is, these very long bonds won't move much in yield. Thus an ever more aggressive Fed results in an ever more inverted yield curve. To illustrate the point, during the Paul Volcker era in the early 1980's, the 2-10 curve slope was at times 200 basis points inverted. I don't think anything like that will happen now, but it shows that severe inversion can result from an especially aggressive policy tightening. Fed Can't Slow Inflation Without Slowing Economy There's no way to sugar-coat this: the Fed has to slow the economy in order to bring inflation down. If inflation is fundamentally a matter of demand outstripping supply, the only thing the Fed can do is make money so tight that aggregate demand declines. A so-called soft landing is the best-case scenario. This is where the Fed manages to push aggregate demand down just enough to arrest inflation, but not so much that a recession ensues. That could definitely happen, but it is tricky. As I said above, the Fed doesn't actually know where neutral is, so it isn't like they can precisely hike just enough to be a little restrictive with policy and then see what happens. All they can do is keep tightening until they start to see inflation slowing, and by that time hope the economy isn't too damaged. What About Stagflation? I'm personally not very worried about so-called stagflation, which is a situation where economic growth is contracting while inflation remains high. However it is a scenario we should consider. Stagflation has to be the result of a severe supply-side contraction, which is how inflation winds up remaining high even as aggregate demand falls. In the 1970s, the oil shock created enough of a supply-side contraction to produce a version of stagflation (although at the time, nominal demand remained very high, so even this episode is debated by economists). For the U.S., I don't think any of the current supply-side problems are close to the severity of the 1970s. But for Europe, the surge in energy prices (and perhaps food prices as well) stemming from Russia's invasion of Ukraine might be more comparable. Europe is also starting from a lower growth trajectory, which means there is less room for error before a recession starts. In fact many observers think a recession may already be underway. Either way, what makes stagflation such a challenge is that the central bank has to tighten to get inflation under control. The lesson of the 1970's is that when prices become truly unstable, economic growth won't recover until inflation is brought under control. In this kind of episode, the central bank is forced to ignore weak growth and focus entirely on inflation. That could result in an especially bad recession. Would the Fed Try to Re-Steepen the Curve? I hear it often suggested that the Fed try to re-steepen the curve. After all, if an inverted curve is such a problem, why not do something about it? There are two problems with this idea. First, the Fed can't effectively steepen the curve even if they wanted to. The idea that is usually suggested is that the Fed actively sell the longer-term bonds they own in their QE portfolio. Presumably all that selling would push longer yields higher and potentially prevent the curve from inverting further. The problem is that markets would know the Fed has limited firepower. Currently the Fed holds about $1.7 trillion in Treasury bonds maturing longer than seven years. That sounds like a lot until you realize that's about 10 days worth of average trading volume. If the Fed started aggressively selling those bonds, I'm sure the curve would steepen initially, but they couldn't keep it up for long. Traders would know that immediately and set up positions for the post-Fed selling world. Any steepening would be short-lived. The other big problem with the Fed targeting a steeper curve is that the inversion is a symptom, not the disease. The inversion doesn't cause the recession, it merely indicates that one might be coming. Artificially steepening the curve would only mask the symptom, not cure the disease. Risk to Earnings Is Real I've been relatively optimistic on the U.S. economy and I remain of the view that a soft landing is quite possible. Household income growth is being supported by an incredibly strong labor market and consequent wage growth. It is possible for wage growth to slow somewhat while supply-chain issues improve, and that combination is enough to bring inflation back down. That could happen with relatively little in real economic pain. However, the risk of a recession is very real. As I said earlier, the Fed is always flying blind, and at present has a difficult inflation problem to handle, which makes their job all the harder. But perhaps just as importantly, it is possible that even mildly slower growth results in a meaningful impact to company earnings. Investors need to not just think of a recession as a yes/no prospect, but rather consider that the Fed is going to do whatever it takes to slow down consumer spending. Even the best case scenario may result in a bumpy ride.

What an Inverted Yield Curve Is Telling Us About a Potential Recession

The inversion that we saw this week is only the beginning -- an ever more aggressive Fed results in an ever more inverted curve.

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