Why the Yield Curve Inverts in One Simple Picture

The yield curve inverts when the Fed keeps hiking in the face of a slowdown.

Bianco research noted today "There has not been one instance where the 2-year 5-year spread inverts and the 3-month 10-year spread didn't."

OK. But Why?

Answer: The Fed kept hiking in the face of a slowing economy as the chart I posted shows.

Thus, whether or not the 3-month to 10-year spread inverts may very well depend on how many more hikes the Fed gets in.

It's possible that that the 3-month to 10-year spread will invert anyway, but it wouldn't have at zero.

Economy Poised to Weaken

Please consider DoubleLine's Gundlach: Treasury curve inversion signal 'economy poised to weaken'.

Jeffrey Gundlach, chief executive officer of DoubleLine Capital, says the U.S. Treasury yield curve inversion on short end maturities are signaling that the “economy is poised to weaken.”

Gundlach, known on Wall Street as the Bond King, said the Treasury yield curve from two- to five-year maturities is suggesting “total bond market disbelief in the Federal Reserve’s prior plans to raise rates through 2019.”

Bond Market Disbelief?

Gundlach's first comment is accurate. His second comment is wrong.

Inversion does not imply in and of itself the Fed will not hike. It does suggest the Fed has already hiked more than the economy can take. Rate hike probabilities provide the proof.

Rate Hike Probabilities

As shown above, the market has a 69.6% chance of at least two more rate hikes in 2019. A month ago it was 87.4%. So the market has started to lesson the odds.

Rate Hike probabilities are from CME FedWatch. The anecdotes are mine.

Inversion Not a Recession Requirement

Let's return to a statement I made at the top: Thus, whether or not the 3-month to 10-year spread inverts may very well depend on how many more hikes the Fed gets in.

Nearly everyone seems convinced the bond market will give its standard recession signal in a timely fashion. That is to say, nearly everyone is convinced the two-year to 10-year if not the 3-month to 10-year spread will invert.

Don't count on it. Japan has had numerous recessions where its yield curve did not invert at all. The US could easily do the same.

Inversion is not a recession requirement.

Mike "Mish" Shedlock

Comments
No. 1-5
VPKK
VPKK

No worry. 10Y will go to 6% in 3 yrs according to Gundlach ...

killben
killben

In case the recession arrives, stopping the rate hikes may not be enough. So is the Fed likely to stop QT too?

BillinCA
BillinCA

The pace of the sustained rate increases this time around is the slowest I've observed in the FRED data going back to the 1950s and 60s.

It will be interesting to see this time around how the pace of the increases impact the pace of economic growth and the risk of recession. This time, it took the Fed 36 months to go +2% (from 0.12% in Nov. 2015 to 2.2% in Nov. 2018) . Last time, they went twice as fast at +4% in less time (25 months from 1.03% to 5.24% Jun 2004 to Jul 2006) ...and that didn't end well...

However, at the end of the day, it's not about the pace but the absolute values; but, pace is still important as the economy needs to adjust and accommodate for these increases via changing business decisions and consumer behavior. Of course, the government fiscal policy needs to adjust too to account for the increased interest payments and overall cost of debt, but I've given up long ago on rational fiscal policy.

Blacklisted
Blacklisted

Those that don't understand the real reasons behind Fed actions will continue to be bewildered. The Fed kept rates to low for too long because of international pressure from foreigners holding too much dollar-based debts, at the expense of pensioners and savers. With the pension crisis now on center stage, foreign and domestics debt holders will need to take a back seat.

DFWRealEstate
DFWRealEstate

"Japan has had numerous recessions where its yield curve did not invert at all." I'm afraid you are probably correct. If we have learned anything in the last few years, it's that central bankers have no appreciation for the wreckage/distortions they have caused. There are consequences for trying to suspend the laws of gravity and preventing true market price discovery. You can delay the price discovery or transfer it to another entity (i.e. U.S. taxpayers, retail investors), but the bill still comes due.

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