Inverted-Yield Curve Isn't Really Such a Curve Ball

The U.S. yield curve finally inverted, according to the classic definition, on Wednesday. The 10-year was yielding less than the 2-year. This came one day after the Consumer Price Index beat to the upside and President Donald Trump appeared to soften his stance on Chinese trade. What does all this mean for the Federal Reserve and interest rates? Here are my thoughts and how I'm positioning now. Curve Inversion Isn't Special The shape of the yield curve is an important indicator of the stance of monetary policy. In simple terms, the yield of any given bond is equal to the market's expectations for short-term rates into the future, plus some premium for uncertainty. In other words, the 2-year Treasury should be roughly equal to the market's expectation for the average overnight yield for the next 720 days. The 5-year for the next 1,800 days, and so on. Of course, the further out you go, the more uncertain anyone can be about where Fed policy will go. For example, when trying to price the 10-year Treasury, no one has a precise forecast for where Fed policy is in the eighth year. So, it is better to think of every Treasury bond as having four components: Near-term Fed expectations Intermediate-term growth expectations Long-term steady-state growth and inflation estimates A premium for uncertainty, especially around the intermediate-term growth expectations, long-term steady-state growth and inflation. Shorter bonds are mostly concerned with near-term Fed expectations, whereas 30-year bonds are mostly concerned with long-term steady-state growth and inflation estimates, and that premium for uncertainty around the intermediate-term growth expectations, long-term steady-state growth and inflation. Everything else is some mix. If you think in terms of this frame work, then you can see why flipping from slightly positive slope to slightly negative slope isn't super important. If the 10-year rate is about the same as the 2-year rate, it is telling us that whatever rate cuts are priced in aren't going to be enough to get intermediate-term growth to improve. Whether that slope is +3 or -3 doesn't change that story much. What Will the Fed Think of the Inversion? While I think the Fed would agree with my point above, the fact that the slope is moving in the wrong direction will worry it. It is only one of several worries though: Signs of flagging business confidence, weaker growth overseas, the trade war, and the lack of firepower left to fight a slowdown. But I still think talk of a 50 basis point cut in September is quite premature. Tuesday's Consumer Price Index release will give some pause. What if inflation really is rebounding? Remember, the Fed has been saying that the inflation softness was due to transitory factors. While I panned that excuse, I take the Fed's word that on it. Given that, put yourself in the Fed's shoes. If you thought the inflation dip was transitory, then you start seeing signs that inflation is rebounding, you'd at least want to see that play out. I actually think if the market weren't rioting, the Fed might be inclined to not cut at all at the next meeting. As it is, it will cut 25bps in September, and then will act further depending on how the data comes in. I think the statement coming out of September will indicate further cuts are likely, but not a given. This is a recipe for the curve to become even more inverted. Could Bad News Be Good News Again? I've been railing against the narrative that stocks should like anything that makes rate cuts more likely. Ultimately weak earnings growth will hurt the stock market much more than low rates will help. But I do think there will be a relief rally if the Fed gives us some more dovish talk. That won't change the ultimate narrative though. If stocks are going to finish 2019 higher, than where they are now it will be because the economy is back on track. Not because lower interest rates goose price-to-earnings ratios. Trades I Like Now Long 5-10 year bonds This has been my favorite trade all year, and keeps working very well. To reiterate, the upside to this trade is that we go into recession, in which case I expect the 10-year yield to decline to 1% or less. The downside is very limited. Long-term rates won't meaningfully rise unless the market starts pricing in rate hikes, a possibility that is so remote as to be safely ignored. The 10-year could trade back to 1.80% or so, but losses beyond that are highly unlikely. Long USD The dollar should strengthen until such time as the Fed capitulates and starts cutting aggressively. The broad U.S. Dollar Index (DXY) index is about 0.5% higher since I wrote about this last week, and I still think there is good room to run. The Japanese yen looks especially overbought, so that isn't a bad pairing, if you want to get specific on your dollar trade. Short 2-Year Treasuries I mentioned doing a tactical short on the 2-year last week with a target yield of 1.65%. I said at the time you needed to be extremely disciplined about that trade due to the high volatility in rates right now. The trade worked if you did it, but you should have covered Tuesday when we hit my target. The 2-year has since traded back to 1.58%, so you would have given up a lot of your gain on the short if you waited even a day to cover. I'm not about to get back in this trade. I was mainly betting on talk of a 50bps September rate cut dying down, and right now Fed funds futures are showing about a 20% chance of such a cut. There isn't enough upside for me there.

Inverted-Yield Curve Isn't Really Such a Curve Ball

Why this much-hyped move isn't so special and how to play it to your advantage.

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