Inverted yield curve is no cause for panic….yet

10-Year Treasury yields continue to fall. A Trend Index peak below zero signals strong selling pressure (purchases of bonds).  Target for the decline is primary support at 2.0%.

10-Year Treasury Yields

The spread between 10-Year and 3-Month Treasury yields is at zero, warning that the yield curve is about to invert. While there is no cause for panic, an inverted yield curve is a reliable predictor of recession within 12 to 18 months, preceding every recession since 1960*.

*1966 is an arguable exception. Initially classed as a recession by the NBER, it was later reversed and airbrushed out of history.

10-Year minus 2-Year Treasury Yields & Bank Credit

The 10-year/3-Month spread last crossed below zero in August 2006 and was followed by a recession in December 2007. While credit conditions tighten when the yield curve inverts, there is considerable lag and the chart below shows that credit growth remains high while the yield curve is inverted.

Yield Curve Inversions & Bank Credit

A far more imminent warning (of recession) is when the yield differential recovers above zero.

Why does a recovering yield curve warn of impending recession?

First, you need to understand what causes the yield curve to invert. Economic prospects weaken to the extent that bond investors are prepared to accept lower long-term yields than the current short-term yield, in anticipation that interest rates will fall. The inverted yield curve will continue for as long as rates are expected to fall but will rapidly recover when the Fed starts to cut rates.

Treasury Yields

Falling short-term yields flag that the Fed is cutting interest rates, confirming bond investors earlier suspicions of a weakening economy. That serves as a reliable warning, after an inverted yield curve, of impending recession.

We are not there yet. The Fed may have eased off on further rate rises but is still some way off from cutting rates.

The Fed and Alice in Wonderland

In Lewis Carroll’s Alice in Wonderland a young Alice experiences a series of bizarre adventures after falling down a rabbit hole. The new Fed Chairman Jerome Powell will similarly have to lead global financial markets through a series of bizarre, unprecedented experiences.

Down the Rabbit Hole

In 2008, after the collapse of Lehman Bros, financial markets were in complete disarray and in danger of imploding. The Fed, under chairman Ben Bernanke, embarked on an unprecedented (and unproven) rescue attempt — now known as quantitative easing or QE for short — injecting more than $3.5 trillion into the financial system through purchase of long-term Treasuries and mortgage-backed securities (MBS).

Fed Total Assets

The Fed aimed to drive long-term interest rates down in the belief that this would encourage private sector borrowing and investment and revive the economy. Their efforts failed. Private sector borrowing did not revive. Most of the money injected ended up, unused by the private sector, as $2.5 trillion of excess commercial bank reserves on deposit at the Fed.

Fed Excess Reserves

Richard Koo pointed out that the private sector will under normal cirumstances respond to lower interest rates with increased borrowing but during a financial crisis, when their balance sheets have been destroyed and their liabilities exceed their assets, their sole focus is to restore their balance sheet, using surplus cash flow to pay down debt. The only way to prevent a collapse is for the government to step in and plug the gap, borrowing surplus capital and investing this in infrastructure.

One Pill Makes you Larger

Fortunately Bernanke got the message.

US and Euro Area Public Debt to GDP

… and spread the word.

Japan Public Debt to GDP

And One Pill Makes you Small

Unfortunately, other central banks also followed the Fed’s earlier lead, injecting vast sums into the financial system through quantitative easing (QE).

ECB and BOJ Total Assets

Driving long-term yields to levels even Lewis Carroll would have struggled to imagine.

10-Year Treasury Yields

The Pool of Tears

Then in 2014, another twist in the tale. Long-term yields continued to fall in Europe and Japan, while US rates stabilised as Fed eased off on QE. A large differential appeared between US and European/Japanese rates (observable since 2014 on the above chart), causing a flood of money into the US, in pursuit of higher yields.

….. with an unwanted side-effect. The Dollar strengthened. Capital inflows caused the trade-weighted value of the US Dollar to spike upwards beween 2014 and 2016, damaging US export industries and local manufacturers facing competition from foreign imports.

US Trade-Weighted Dollar Index

The Mad Hatter’s Tea Party

A jobless recovery in manufacturing and low wage growth in turn led to the election of Donald Trump in 2016 promising increased protectionism against global competition.

US Manufacturing Jobs

Then in 2017, to the consternation of many, despite rising interest rates the US Dollar began to fall.

US TW Dollar Index in 2017

Learned analysis followed, ascribing the weakening Dollar to rising commodity prices and a recovery in emerging markets. But something doesn’t quite add up.

International bond investors are a pretty smart bunch. When they look at US bond markets, what do they see? The new Fed Chairman has inherited a massive headache.

Donald Trump is determined to stimulate job growth through tax cuts and infrastructure spending. This will certainly create jobs. But when you stimulate an economy that is already at full employment you get inflation.

Who Stole the Tarts?

Jerome Powell is sitting on a powder keg. More than $2 trillion of excess reserves that commercial banks can withdraw without notice. Demand for bank credit is expected to rise as result of the Trump stimulus. Commercial banks, not known for their restraint, can make like Donkey Kong with their excess reserves provided by the Bernanke Fed.

Under Janet Yellen the Fed mapped out a program to withdraw excess reserves from the market by selling down Treasuries and MBS at the rate of $100 billion in 2018 and $200 billion each year thereafter. But at that rate it will take 10 years to remove the excess.

Bond markets are worried about what will happen to inflation in the mean time.

Off With His Head

The new Fed Chair has made all the right noises about being hawkish on inflation. But can he walk the talk? Especially with his $2 trillion headache.

….and the Red Queen, easily recognizable from Lewis Carroll’s tale, tweeting “off with his head” if a hawkish Fed threatens to spoil the party.

One pill makes you larger
And one pill makes you small
And the ones that mother gives you
Don’t do anything at all
Go ask Alice
When she’s ten feet tall

….When the men on the chessboard
Get up and tell you where to go
And you’ve just had some kind of mushroom
And your mind is moving low….

When logic and proportion
Have fallen sloppy dead
And the White Knight is talking backwards
And the Red Queen’s off with her head
Remember what the dormouse said
Feed your head
Feed your head

~ White Rabbit by Grace Slick from Jefferson Airplane (1967)