INSIGHTS

On December 04, 2018

The Perversion of Inversion

The inversion of certain maturities in the yield curve has increased concern about the acceleration of the end of this historic expansion. We have long held that the inversion is a key indicator, however, it must be put not only in context but also explained as to how the current cycle is exacerbating the potential timing of the signal.

Historically, the timing of the inversion has always given ample notice before the recession and market top occurs. Consider past 10-year and 2-year Treasury initial inversions and the subsequent recession and market tops (Russell 3000 used as it covers 98% of all traded equities).

Source: AAM | Data from NBER, Bloomberg and Russell Investments

If all else being equal, the market and economic actions that need to be taken have the potential to be pushed out for a year and a half. However, there are certain anomalies that have occurred that make the current reading more premature than normal.

• The Federal Reserve’s balance sheet has swollen to levels never seen in history. It currently stands at $4.09 trillion and is comprised of roughly 59% U.S. Treasuries and 41% Mortgages.


• 62% of the holdings mature in the next five years with 38% maturing in greater than five years. Of the long-term holdings maturing in greater than 10 years, 27% of the Treasury holdings and all mortgage backs increase the convexity of the Fed’s portfolio.


• As a percentage of GDP, it has declined from its all-time high of 25.5% in September 2014, but it’s currently still at 20%. That compares to the average of 5.7% from 1990-2007.


• Expected net Treasury issuance for 2019 looks to be over $1.25 trillion, a net increase of 5.7% from the total outstanding in 2018. This comes at a time when rates have been rising, foreign demand has declined, increased inflation, increased wage pressures, and budget deficits will be under increased scrutiny.

The balance of these measures are arguments for a potential Treasury put perception that has flattened the shape of the curve. However, another issue is quantitative easing in Japan and Europe. As their sovereign debt yield compared to U.S. Treasuries becomes a comparison for a risk-off move, a 10-year German Bund unhedged yield of 0.26% and a Japanese 10-year government unhedged bond at 0.08% makes a 2.93% U.S. Treasury unnaturally attractive. Yet, the foreign demand has not risen relative to U.S. households who have accumulated $1.8 trillion in U.S. Treasuries, up from $400 billion only a few years ago. Should the rates in Europe and Japan increase even slightly, we would expect more pressure on foreign demand for Treasuries…and thus more pressure on shifting outward on the curve, or at least giving an earlier signal of an inversion than normal.

Lastly, there are two charts that seem to have gone completely unnoticed when tracking the Federal Reserve’s Fed Funds Rate and how it compares to the 2-year Treasury and the Real Rate at the start of recessions.

Currently, the 2-year Treasury is 55 bps (basis points) above the Fed Funds Rate. At the start of each recession it was either at its most negative or coming off its most negative spread. At the most benign negative spread, the current 2-year Treasury would have to be 140 bps below the Fed Funds rate to trigger an immediate recession. Assuming the higher end of the Fed Dot Plot, a Terminal Fed Funds Rate of 3.50% (five more quarter-point hikes from here ending in early 2020), one would have to see the 2-year yield drop to 2.10% from its current 2.81%.

Lastly, the measure of the Real Fed Funds Rate just recently went negative. The Personal Consumption Expenditure year over year, minus the Fed Funds Rate, now stands at -47 bps. For comparison, the average over the last 30 years is -113 bps. Historically, it hits an average negative yield of -445 bps prior to the start of a recession – or 400 bps from here.

These charts from Bloomberg display that we have several metrics that likely are a significant period away from warranting a heightened level of anxiety based on the curves. We believe the conclusion one should make is that the current inversion of several curves only affirms an extremely early signal. While the markets are displaying risk-off moves and it looks to continue through year end, putting on snow tires in the middle of August seems a bit premature.

CRN: 2018-1204-7086R