This is a guest post by Jim Bianco. I dispense with block quotes. The end of the article will be clear.
Jim’s View: Why and How The Curve Inverts
We have voiced our concerns that the Fed may be hiking in the face of higher inflation expectations without any actual inflation materializing. This type of action often leads to an inverted curve and recession. Today we examine previous instances when this has happened.
Why Does The Yield Curve Flatten?
Often the yield curve inverts when the Fed misreads inflation signals and hikes rates too fast. This can be seen in the chart below which shows the last six recessions.
The top panel shows the 3-month/10-year yield curve in blue. On average it inverts roughly a year before a recession (range is 6 to 18 months).
The orange line in the second panel shows the target federal funds rate. Notice the Fed was hiking rates in every instance prior to an inverted curve. There are no examples of the curve either inverting or materially flattening without a Fed hiking campaign.
Why does the Fed aggressively hike? The brown line in the third panel shows the Institute of Supply Management’s (ISM) Prices Paid Index. This is a survey of purchasing managers’ opinions about the prices they are paying. Many economists think this is the holy grail of predicting inflation. We argued that it is actually not that good a metric. Nevertheless, the Fed closely watches this metric and when it gets too high, they take it as a sign that inflation may be returning.
Assuming inflation actually returns, all is well. The Fed is correctly leaning against the markets. However, this is not always the case. The red line in the bottom panel shows the Fed’s favorite inflation measure, core PCE. By our count, the Fed has engaged in nine rate hike campaigns. Since 1980, inflation has been in a downtrend. PCE has rarely exceeded 2% since 1997. Each time it has, the Fed aggressively hikes, the curve inverts and a recession ensues about a year later.
The Curve Is Smooth
The Bloomberg graphic below shows today’s Treasury yield curve (top solid green line), the curve from 1 year ago (middle gold line) and the curve from 2-years ago (bottom dashed green line). We show this to remind us of the obvious, the curve is smooth. It rarely kinks up or down between maturities.
How The Curve Inverts
It is important to note the curve is smooth as this fact makes the next chart important. It shows three different curves – the 5yr/10yr curve in red, the 3yr/10yr curve in orange and the 3m/10yr curve in blue.
Note that in every instance the 5yr/10yr curve inverts first, followed by the 3yr/10-year curve and then the 3m/10yr. Typically a recession follows about a year after these inversions.
This is how it should be given the smooth nature of the curve. It inverts from the inside out. Also note that, other than a few instances in the 1980s when the curve inverted by fewer than 5 basis points, once the 5y/10yr curve inverts, eventually the rest follow. Since 1989 there are no instances when the 5yr/10yr curve inverts in isolation.
While some of the more obscure yield curves are getting close to inverting, most people watch the 3m/10yr curve. At 1.02%, it is not yet at risk of inverting. If, however, the Fed continues to hike without inflation materializing, this could quickly change. The market has seen this movie before. So far, the script is playing out as expected.
The above article is from June 5, but hardly anything has changed. It follows what I have been saying, but Jim's article is more precise.
As of July 1, the 5-10 spread is still 12 basis points (0.12 percentage points), sinking slowly from 15 basis points on June 5.
Here is the key takeaway: "Since 1989 there are no instances when the 5yr/10yr curve inverts in isolation."
The script is playing out, but whether it remains "as expected" will depend on who expects what.
No Crystal Balls
Just because the market usually gives a recession warning of approximately a year, does not mean we will get that year.
I expect we won't. There are simply too many things going on with tariffs, in Europe, and in China.
But don't count on my crystal ball. It's been broken for some time. Then again, no one has a crystal ball, at least one that is accurate.
Mike "Mish" Shedlock