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Financial Industry Insights from Advisors Asset Management

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The Yield Curve Briefly Inverted, Now What?


Earlier this month we had a brief inversion of the yield curve, and thus began the ubiquitous debate of the recession countdown clock. Mechanically this makes sense: The yield curve has typically inverted late in the cycle because this is when central banks raise short rates (or are expected to) to tighten policy. The short end of the Treasury curve generally follows suit. Conversely, the long rates are generally more a factor of long-term growth and inflation expectations and thus have not mirrored movements in the short rates (exhibit 1). With the curve inverted at this level (high 2% range), it tells us that the market believes (as do we) that the Federal Reserve (Fed) will be successful at keeping long-term inflation expectations anchored, albeit likely creating a recession to achieve these results.

Exhibit 1: 2-year/10-year Treasury spread (June 1976-March 2022)

2-year/10-year Treasury spread (June 1976-March 2022)
Source: Haver Analytics. As of March 31, 2022.

However, the lead time of curve inversion to recession could be more than two years, so it’s not the best timing tool. However, what we do know with more certainty is the signaling that the economy is now firmly in the late cycle. How long the late cycle lasts is ultimately a function of the Fed’s path of monetary policy. Typically, the Fed aims to normalize policy by increasing the policy rate to around the neutral rate thereby taking the proverbial “foot off the gas” and (hopefully) navigating a soft landing (no recession). When ‘Volckerizing’*, stopping inflation becomes the main driver of policy decisions and as a result, the policy rate goes well above neutral to contract demand to ease inflationary pressures. In essence, the central bankers kill inflation, but they kill the economy as well (recession).

US Federal Chair Powell and company have clearly expressed their intention to Volckerize given the uncomfortably high inflation prints. While the communication has been very hawkish (implying higher interest rates ahead), we believe the rubber will meet the road sometime in the fourth quarter of this year. At that point, the federal funds rate will most likely be close to, if not at, 2%. From here, the next steps would be into restrictive policy zone. Currently, the forward curve is pricing in a 2.5% rate by year-end and a peak rate around 3.25% by the third quarter of 2023. In addition, the Fed has said it will be reducing its balance sheet by about $2 trillion by the end of 2023. If the Fed follows this path, we believe there is a very high probability of a recession in the second half of 2023 to first half of 2024 period.

Worst case scenario: The supply chain remains clogged and inflation is stubbornly high. Fed is forced to take rates well past neutral while sizably reducing the balance sheet, demand destruction occurs and the economy lands in recession.

Best case scenario: We see a combination of supply chain easing and reversion of war-induced inflation components. As inflation decelerates, the Fed is able to re-evaluate later this year once it gets rates to neutral. We believe this is the best chance for a soft landing.

Road signs of recession: Over the years, we’ve acquired various data points that we watch to determine the likelihood of an impending recession. Here are some:

  1. Output gap: This measures the amount of unused capacity in the economy (exhibit 2). Usually overheating occurs when there is limited capacity left and thus prices become the pressure valve for excess demand. It is extremely rare to have a recession if the output gap is not closed. (It occurred in 1981, but this was only one year removed from the previous recession).

    Current:
    Output gap is closed. (Caveat: the low participation rate’s influence on unemployment is likely skewing the reading a bit higher than actual.) 

    Exhibit 2: US output gap as a percent of potential Gross Domestic Product (GDP) with projections
    US output gap as a percent of potential Gross Domestic Product (GDP) with projections
    Source: Congressional Budget Office, Haver Analytics. As of March 31, 2022.
  2. NIPA profits: Not the S&P or equity profits, but rather, the profits of the US corporations as a whole, including public, private and S-corps, as reported in the National Income of Product Accounts (NIPA) tables. This tends to peak well before the equity market does (exhibit 3). Note: This is a sufficiently lagged number and thus may not be as useful as prior cycles given the rate of change of policy tightening.

    Current:
    4Q21 NIPA profits grew a mere 1.1% annualized. Yes, that slow, but part of that was due to the massive post-pandemic rebound earlier in the year.

  3. Aggregate hours: Given the costs associated with labor separation, companies often tend to reduce hours before they actually start laying off workers (exhibit 4).

Exhibit 4: Aggregate hours: Nonfarm payrolls, private sector SAAR, Bil. Hours (1988-March 31, 2022)
Aggregate hours: Nonfarm payrolls, private sector SAAR, Bil. Hours
Source: Bureau of Labor Statistics, Haver Analytics. SAAR is seasonally adjusted annualized rate. As of March 31, 2022.

Exhibit 5: Aggregate hours: Nonfarm payrolls, private sector % change year-to-year, SAAR, Hours, (1988-March 31, 2022).
Aggregate hours: Nonfarm payrolls, private sector % change year-to-year, SAAR, Hours

Source: Bureau of Labor Statistics, Haver Analytics. SAAR is seasonally adjusted annualized rate. As of March 31, 2022.

Market signals from the curve: The last few late-cycle periods have been decent environments for risk assets. However, during those periods, the Fed was trying to moderate growth, not aggressively stop inflation. The rate of change in monetary tightening cannot be overlooked. This combination of late cycle and the Fed moving very aggressively to tighten policy makes us a little more concerned about the outlook for risk assets in this late cycle period. Thus, while we would not go outright underweight risk just yet, we would look for opportunities to utilize rallies to reduce risk/move up in quality.

CRN: 2022-0401-9906 R

* Refers to Paul Volcker, former Chair of the Fed most remembered for raising the fed funds rate to the highest point in history (20%) to remedy the high inflation of the 1970s which resulted in a recession.

The opinions and views of this commentary are that of Aegon Asset Management and are not necessarily that of Advisors Asset Management.


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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