The Devil Is In The Details

Historically, an un-inverting yield curve is a great recession timing tool.  The yield curve is also un-inverting now. Is a recession imminent? No! Let me explain.

What is an inverted yield curve and why does it matter?

Lending and credit availability are the grease that keeps the economic wheel turning.  Most banks and credit providers borrow on the short end (think short-term rates) and lend on the long end (think auto & home loans).  Lending is a “spread” business, i.e. long rates > short rates = profits.  Short rates > long rates = losses.  During good times, long rates are above short rates, banks lend, and the economic wheel keeps turning.  An inverted yield curve happens when short rates rise above long rates.  The business of lending becomes uneconomic.  Over time, lenders stop lending. 

What causes an inverted yield curve?

In a mature economic cycle, inflation starts to rise. The Fed uses short-term rates as a tool to control growth and inflation. Economic growth and inflation outlook underpin long-term rates.

The Fed raises interest rates, which pushes rates higher.  Higher rates reduce the rate of return on most projects.  Higher rates impact growth.  However, the feedback loops are slow and have long lags.  Therefore, the Fed keeps raising short rates, which dims long-term economic prospects even more.  This causes long rates to fall below short rates.  The inverted yield curve reduces the lender’s appetite to lend.  This further reduces growth. 

The Fed accomplishes its mission of restraining growth and inflation.

What causes an Un-inversion?

Using history as a guide, the Fed keeps rates elevated for too long, leading to substantially weaker long-term growth.  Realizing its mistake, the Fed cuts rates.  The intent is to raise the return prospects on new projects and give banks and financial institutions incentives to lend again.  This should invigorate growth.  Short rates fall because the Fed controls them.  Long rates fall slower than short rates because there is some hope that rate cuts could boost growth.  This creates an un-inversion or a positive yield curve. 

Too Late

Historically, by the time the Fed is aggressively cutting rates, it is too late.  Economic conditions are too weak, and the negative momentum pushes the economy into a recession.  Therefore, the un-inversion is a recessionary leading indicator.

Yield Curve is Un-inverting Now

The yield curve inverted 15 months ago and is now un-inverting.  Is a recession imminent?

What Is Different Today?

Over the past few months, long rates have been rising faster than short rates.  They are rising because investors believe growth and inflation are both higher than previous expectations.  This is a “good Un-inversion”.   Pre-recession, as in the red arrows in the un-inversion chart above, short rates fall faster than long rates.  That is a “bad Un-inversion”. Currently, growth is stronger, not weaker. 

Getting Technical

We are in a “bear Steepener”.  This is bad for bonds.  Historically, imminent recessions are characterized by “bull steepeners”. 

Bear steepeners are rare, have occurred 10% of the time over the past 50 years, and stocks show average returns. 

Stocks have below-average returns during bull steepeners, of course, because the economy is about to fall into a recession.

Markets are complicated, and the Devil Is in The Details.