The Boring Invstr - Your Simple, Digestible Weekly Investing & Finance Newsletter

Welcome Back to The Fifteenth Edition of The Boring Invstr!

Hello Boring Invstrs,

The US Yield Curve is a line chart that depicts the yields of short-term and long-term treasuries. The yield curve revolves around investor and consumer sentiment regarding future inflation, expected interest rates, and future risk.

Typically, the yield curve shows higher yields for bonds with longer maturities and lower yields for shorter maturities.

But in October of 2022, the US yield curve inverted. Short-term securities now yielded more than their long-term counterparts.

Since the 1960s, a recession has subsequently followed every inversion of the US yield curve. While history does not repeat itself, it often rhymes. Proven true by many studies from academia and central banks, the inversion of the US yield curve and a subsequent recession has a correlation, but the inversion does not directly cause a subsequent recession.

The inversion of the yield curve can often influence policies that can drive the possibility of a recession.

Over the past eight months, economists have overwhelmingly called and predicted a recession.

Typically, institutions cut back on lending. Financial institutions borrow in the short term and lend in the long term. In a normal case, this generates a positive interest-rate margin creating a profitable lending-investing ratio. Due to the inversion, the interest-rate margin becomes negative leading to an unprofitable lending-investing ratio.

While banks have tightened lending, there isn’t enough to indicate a looming recession. There are also no signs of a weakening labor market or companies with weak balance sheets or distressed debt.

It is also a common consensus that consumers slow down on borrowing. Currently, there aren’t any signs of a recession when observing consumer spending data.

Over the past few months, many critics are now questioning the validity of the yield curve.

The yield curve is not as simple as an inversion foreshadowing a recession. There isn’t one explanation for the inversion of the yield curve and what it means for the overall economy.

The yield curve reflects long-term sentiment. Long-term bonds generate more returns because investor sentiment is very optimistic for future returns. The same is true in the opposite way.

When the Federal Reserve tightens monetary policy, the yield curve often flattens or inverts as short-term securities become more attractive. Investors lose optimism due to rising interest rates causing borrowing to become less attractive.

We are in an economic time unlike any other in history. The Federal Reserve cut rates to near zero and flooded the economy with stimulus during the Covid-19 pandemic. Many economists at Morgan Stanley believe that the Federal Reserve is trying to play catchup. The same economists also pointed towards a strong global demand for US treasuries and quantitative easing. In other words, the Fed bought back treasuries creating low long-term yields.

Goldman Sachs economists Praveen Korapatay and William Marshall hold a similar view when it comes to why the Federal Reserve is playing catchup. Korapatay and Marshall state, “A large part of the inversion seen in current US yield curves comes not from high recession odds or inflation normalization, but rather from low long-run real rate levels…” Many also state a strong labor market is also helping hold up the economy.

While the economy seems to be in an unprecedentedly strong position with an inversion on the US yield curve, here’s what is scary.

When looking at the spread of the ten-year and three-month rates between 1968 and 2006, all six recessions as defined by the National Bureau of Economic Research (NBER) “have been preceded by at least three negative monthly average observations in the twelve months before the start of the recession” (Estrella & Trubin 2006). Over this period, there was not a single false signal on a monthly average basis regarding an inversion and a subsequent recession.

The inversion of the ten-year and three-month spread has failed to not foreshadowing a recession. It has a perfect track record.

Just because the economy is nearing almost nine months of inversion does not mean we are out of the water yet. Since the yield curve reflects long-term sentiment, the yield curve is forward-looking. Just because the yield curve inverts do not mean a recession occurs within weeks or a couple of months. In fact, according to Richard Salsman, President of InterMarket Forecasting, Inc. and former banker at the Bank of New York and Citibank, an inverted yield curve signals a recession with a lag of 10 to 13 months. In a 1996 study produced by the Federal Reserve Bank of New York, the yield curve is a dominant producer compared to other economic indexes like the New York Stock Exchange (NYSE) Stock Price Index, the Commerce Department’s Index of leading economic indicators, and the Stock-Watson Index between two and six quarters.

This illustrates the yield curve is a significant predictor in recessions anywhere from six months to 18 months. This concurs with Salsman’s time lag findings. Considering that we are eight months in, we are not out of the water when it comes to recession risk.

The closest comparison of circumstances in history would be the 1970s. We saw inflation peaking near 1970s highs as well as a sharp and fast-tightening period to fight fast-rising inflation like the 1970s. The US yield curve inversion between the three-month and ten-year yield rates are even near levels we saw in the 1970s and early 1980s.

In concurrence with Richard Salsman, Arturo Estrella, senior vice president in the Capital Markets Function of the Research and Statistics Group, and Mary R. Trubin, a Ph.D. economics student at Northwestern University found that more pronounced inversions are associated with “deeper subsequent recessions” (Estrella & Trubin, 2006). Salsman elaborates in further detail writing that there is a correlation between initial duration, depth of the curve, and length and depth of the recession. Unfortunately, the last time there was this much inversion, the economy was plagued with a decade of high inflation and multiple periods of negative growth.

Fortunately, Federal Reserve Chairman Jerome Powell has released statements stating how the Federal Reserve is considering the lessons they learned from the 70s and 80s. Powell has also released statements in the past months stating there is not likely to be rate cuts this year and has threatened to raise rates again.

The US yield curve has a perfect track record of foreshadowing recessions, but we are in economic conditions unlike any other in history. It’s as if a strong labor market, strong consumer spending, and strong company balance sheets are playing tug of war with high inflation and the inverted yield curve. While we can make comparisons to the past, history does not repeat itself. History rhymes and lessons can be learned, but no one knows what the next economic year will contain.

Extra:

If you are a probability and numbers geek like I am, the Federal Reserve Bank of New York releases recession probability data. A screenshot is below with data dating from January 2022 citing the spread between ten-year treasury and three-month treasury yields and the probability of a recession.

If you prefer charts over tables, a chart from the Federal Reserve Bank of New York is below the table containing similar data with monthly averages.

That’s all for this week! I hope you enjoyed!

Trey

Sources:

1. "Low Treasury Yields: A Self-Fulfilling Prophecy?" Federal Reserve Bank of New York, Current Issues in Economics and Finance, Volume 12, Number 5, 2006. Accessed July 16, 2023. Link

2. Salsman, Richard. "The Inverted Yield Curve and the Next US Recession." American Institute for Economic Research, August 14, 2019. Accessed July 16, 2023. Link

3. "Yield Curve Frequently Asked Questions." Federal Reserve Bank of New York. Accessed July 16, 2023. Link

4. "Understanding the Yield Curve, Part 2: The Recent Evolution of the Yield Curve and Its Potential Implications for the Outlook." Federal Reserve Bank of New York, Current Issues in Economics and Finance, Volume 2, Number 7, 1996. Accessed July 16, 2023. Link

5. "Why This Yield Curve May Not Signal a US Recession." Goldman Sachs Research, November 29, 2018. Accessed July 16, 2023. Link

6. "Inverted Yield Curve: Recession Outlook." Morgan Stanley Ideas, March 4, 2019. Accessed July 16, 2023. Link