Yield curves, specifically INVERTED yield curves, are one of my favorite topics.
Perhaps because they precede big moves lower in mortgage rates.
Certain yield curves, once inverted, have an almost perfect track record for predicting recessions.
An inverted yield curve is when a shorter-term bond has a higher yield than a longer-term bond.
This is unusual because the longer the duration of a bond, the more risk the investor is taking, and therefore should be compensated with higher yield.
There are specific yield curves the market watches closely, including the 2-year and 10-year curve, as well as the 3-month and 10-year curve (supposedly what The Fed prefers).
However, in most cases it is splitting hairs which curve to follow, especially when we consider the massive level of inversion various yield curves experienced this year.
Why do INVERTED yield curves matter?
In the most simplistic sense, banks borrower short and lend long, profiting from the difference in interest.
When yields invert, banks are no longer incentivized to make loans since it would be a losing proposition to borrower short at rates higher than what would be collected from the interest on the longer duration loans they would make.
This leads to credit contraction (decelerating loan growth), which is one culprit of the liquidity issue markets are experiencing currently.
However, in our credit-based financial system, if loan growth does not expand perpetually than the economy contracts, as does the money supply.
This can create a negative feedback loop, eventually leading to a recession or an even more catastrophic market event.
The Fed raising their overnight lending rate (Fed Funds) causes short-term bond yields to increase as the market responds to Fed policy changes and other relevant economic data such as inflation reports.
The credit “tightening” from both The Fed and the bond market slows the pace of economic growth.
Investors, fearful of the risks from a slowing economy, seek the safety of fixed income (cash flow) as a preferred “risk-off” hedge against potential near-term market shocks.
Bond yields (rates) are inverse the price.
Therefore, as the demand for long duration bonds increases, and the price rises, the rates on these bonds fall.
Eventually rising short-term rates move higher than longer-term rates, creating an inverted yield curve.
The deeper and longer the inversion, the worse it implies the recession will be once it arrives … and as I mentioned, inverted yield curves have an almost perfect track record for predicting recessions.
The last 8 recessions in the US were all preceded by an inversion of 10-yr and 3-mo Treasury yields.
That inversion occurred last month for the first time since 2020.
It has quickly inverted at a dramatic pace to over 80 basis point (0.80%).
The time in which it has remained inverted is also troubling.
The 2-year and 10-year spread also has a strong track record for predicting recessions.
It inverted deeper this year than in 2001 and 2008.
At one-point, 10-year Treasuries offered a yield 77 basis points lower than the 2-year, the largest negative gap since the 1980’s.
However, it’s not limited to comparisons with the 10-year.
The 3-month T-Bill has even inverted with the 30-year bond. This is the first time since 2019 and the most it has inverted since April 2007.
Here is each time the 3-month inverted with the 30-year and when a recession occurred (100% of the time).
1989 – Recession 1990-91
2000 – Recession 2001
2006 – Recession 2008-09
2019 – Recession 2020
2022 – ?
In fact, the entire US yield curve inverted this year.
The last two times this happened, was August 2007 and Aug 2019.
Both times recession followed within 6-months. (the US was already headed into recession prior to the Covid lockdowns).
Not only are all U.S. Bonds inverted, but in November The Fed Funds Rate inverted with the 30-year Treasury Rate.
The Fed overnight lending rate, which is what they raise and lower when you hear “The Fed raised rates”, is higher than the longest duration U.S. Government Bond.
This is now even more extreme after the Fed hiked another 50 basis points on December 15th, lifting the Fed Funds Rate to 4.25 – 4.50%
Think about what the market is signaling – Banks would rather lend to the U.S. Government for 30-years than overnight to each other.
Inverting yield curves are not isolated to the US.
Just as inflation has been global, so has rate hikes from global central banks, and now global bond yields have also inverted suggesting a global rescission is likely.
When the U.S. sneezes the world catches a cold.
The last time we had a global financial crisis (absent a pandemic) was the 2009 housing crisis.
Will the highest mortgage rates in over 20-years lead to another housing collapse?
Find out in part 5, the FINAL piece in my financial markets “2022 Year in Review”.
FINANCIAL MARKETS 2022 YEAR IN REVIEW
PART 1 | PART 2 | PART 3 | PART 4 | PART 5
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