More Yield Curve Bad News and Questions

Too often when it comes to economics and finance, previous trends—correlations, to be specific, like that between yield curve inversions and eventually recessions—come to be treated as inviolate natural law. That can lead to significant risk and strategic mistakes.

When there’s a yield curve inversion, with interest rates on shorter-term bonds being higher than on longer-term, frequently, although always, there’s eventually a recession within a year or so. The explanation is that collectively investors as the “market” perceive that the economy will slow over the longer run, with the Fed lowering short-term rates to prevent a recession. That means when bonds come to maturity, rates will be lower, meaning they won’t make as much by reinvesting, so they demand higher interest rates on short-term bonds to make up the difference.

Yield curves have been inverting of late, but Marcus & Millichap recently noted factors that might throw off the interpretation of yield curve inversion. High inflation and responding rapid interest rate increases by the Fed have pushed up short-term Treasury bond rates faster than longer-term ones. Geopolitical churning—the Russian war against Ukraine, escalating dissent and protests in such places as Iran and China—drive investors to seek safer havens for their money, like 10-year US Treasury bonds, driving prices up and yields down. Marcus & Millichap’s observation is that these pressures are squeezing rates in opposite directions and creating an unusual type of inversion.

But … so/? Markets are collections of people and human beings respond emotionally to things. Mechanical pressures from two directions creating inversion and concern about recession isn’t something that will automatically fizzle away.

For example, when Marcus & Millichap did the analysis, the firm could say there hadn’t been an inversion between the three-month and ten-year bonds. That’s no longer the case. As the Federal Reserve Bank of St. Louis has been reporting, the yield on a 3-month has been higher than that of a 10-year and not just momentarily, but for weeks. According to Christopher Waller, a Fed governor now but when he made this 2018 presentation the director of research at the St. Louis Fed, the 3-month/10-year inversion has presaged a recession in 7 out of 9 recessions between 1957 and the Great Recession.

How about the pandemic recession? There was a 3-month/10-year inversion for an extended period in 2019.

“Historically, when you get a sustained inversion like this […] it’s a very reliable indicator of a recession coming,” Duane McAllister, a senior portfolio manager at US firm Baird Advisors, told Morningstar.

Economic growth seems like it’s come back if the early indicator of the Atlanta Fed is correct and annualized Q4 GDP growth is really 4.3%. Even with high-tech layoffs, employment markets have continued to be strong. The Fed seems unlikely to be ready to drop rates.

Maybe the signs aren’t right but ignoring them could be very wrong.