Wednesday, December 7, 2022

About that yield curve inversion ...

Conventional wisdom says that an inversion of the Treasury yield curve is a good predictor of a forthcoming recession. Today the yield curve is more inverted than at any time since the early 1980s, so many are saying that means the chances of a recession are pretty high. The curve is strongly inverted because the bond market figures that a recession will force the Fed to reduce short-term rates in the future, but not immediately—in fact the market expects at least one more tightening of 50 bps and possibly another within 4-5 months.

I've discussed this subject many times here on this blog, and I've tried to make the point that while an inverted yield curve has indeed preceded every recession, so have other indicators: e.g., very high real yields, high swap and credit spreads, and rising unemployment claims. None of those other indicators are flashing recession signals right now. Plus, the current Fed tightening cycle is very different this time than at any other time before. The Fed no longer drains liquidity in order to push short-term rates higher, and that means a lot less pressure on the banking system. Liquidity today is in fact still abundant.

I've also pointed out that the inflation problem we're experiencing today is unique: unlike all other tightening cycles (nearly every one of which preceded a recession), the Fed was fighting an inflation that the Fed itself caused (i.e., by being too easy for too long). This time around, the inflation was the result of massive government spending (transfer payments) that came at a time when the economy was in lockdown and risk aversion was very high. People welcomed the cash and let it sit in their bank accounts. But starting early last year the cash wasn't so welcome or needed, so people started spending at a time when the economy wasn't ready to meet the demand, and inflation was the result. So the inflation problem this time is more temporary in nature, and thus should be easier to resolve. And in fact it is being resolved as we speak: witness the strong dollar, falling commodity prices, falling housing and commercial property prices, and the fact that most measures of inflation peaked some months ago.

Add it all up and I think the odds of a recession are lower than the market is priced for, which implies that the Fed is likely to hike rates less than the market expects.

Some charts to illustrate:

Chart #1

Chart #1 shows the slope of the Treasury yield curve (red line) and the real Fed funds rate (blue line). Note that an inverted curve and high real rates have always preceded recessions. Yes, today the curve is very inverted, but real yields are not particularly high. High real yields crush debtors, but that's not the case today.  Note how low credit spreads are in the next two charts.

Chart #2

Chart #2 shows the level of 2-yr swap spreads. When low, these spreads suggest that the outlook for the economy and corporate profit is good, and liquidity conditions are plentiful. Spreads today have been this high many times without a recession following.

Chart #3

Chart #3 shows credit spreads for investment grade and high-yield corporate bonds. Low spreads suggest the market is relatively confident about the outlook for corporate profits and that in turn implies the outlook for the economy is healthy. Although they are somewhat elevated, they are nowhere near the levels we see prior to or during recessions. 


John A said...

"And iso the Fed is likely to hike rates less than the market expects."


I've read several times that the inflation we've been getting lately was more akin to the brief inflation after WWII. Is there a way to compare non-yield curve financial conditions back then to what we've been seeing lately?

Scott Grannis said...

John, thanks for spotting that typo, now fixed. I think you have a good point about the inflation episode which followed WWII. Back then the economy was going through a huge post-war transition. Lots of enthusiasm, lots of demand for things (non-war stuff) that were not in great supply. A sort of demand shock. In a sense that’s what we had early last year.

Salmo Trutta said...

DXY down 8% from high. No "soft landing" for U.S. Treasury.

Salmo Trutta said...

Using monetarism, legal reserves always pointed to a recession. With DDs, now the inflection point is not as sharp.

Is the deflator really, right?
Q3 2022: 4.3 too low
Q2 2022: 9.1
Q1 2022: 8.4
Q4 2021: 6.8
Q3 2021: 6.2

Michael Meyers said...

I’m with you when you say the odds of a recession are lower than the market expects, but I don’t understand how that implies the FED will hike rates less than the market expects.

Scott Grannis said...

Michael: That’s an excellent question. My rationale for saying that the odds of recession are lower than the market expects is based on my observation that there are very few signs of recession at this point: credit and swap spreads are relative low, liquidity is abundant, jobs are expanding and unemployment claims are low. Abundant liquidity is the one thing that is so different this time around, because it allows the market to adjust naturally rather than chaotically. And basically I have never thought that a recession was the only way to bring down inflation. I see it coming down already with few signs of distress.

I think the market is expecting the Fed to raise rates more than will be necessary to bring inflation down, and that’s why I think they will end up raising rates less than expected. Today the market is still expecting the funds rate to rise to almost 5%, then decline by the end of next year and the following year. If the signs of lower inflation become clear in the next few months, the Fed will have a pass to forgo further rate hikes.

The market seems to always have a bias towards Phillips Curve thinking, which says that inflation is a by-product of an economy that is “running hot,” and that the only way to bring down inflation is to weaken the economy. I don’t believe that’s how things work. In fact, a strong economy which produces a lot can actually experience lower inflation, since the supply of goods can at times exceed the demand for them. Inflation is the by-product of excess money, not the result of economic growth. Today, higher interest rates are mitigating the problem of excess money, and supply chains have been rebuilt, which means more goods are being supplied, so that reduces inflationary pressures. The Fed simply doesn’t have to do more than they already have.

And I think Powell is loathe to do something (e.g., tighten even more) that might precipitate a recession and/or a housing market collapse. In the end, he is going to follow my advice and give the economy a tincture of time.

Of course, I could be wrong, but only time will tell.

Adam said...

Thanks a lot, your explanation of the current inflation episode really makes sense to me.

Mark F. said...

How, if at all, do labor costs figure in your analysis?

Scott Grannis said...

Re Mark “How, if at all, do labor costs figure in your analysis?”

The cost of labor does not create inflation. Typically, labor costs rise after inflation rises. If labor becomes more productive, then labor costs can rise even if there is little or no inflation; that is what drives improvement in living standards.