INSIGHTS

On May 15, 2023

AAM Viewpoints — Fun Facts Surrounding the Yield Curve and Recessions

I have been lucky enough to have participated in the financial markets for nearly 40 years. During that time, I have witnessed interest rates range from double digits to negative. I have been through many recessions as well as a couple of wars. I have seen the financial system crash at least two times. In all those instances I learned firsthand that the bond market gets it right long before the equity markets do. In all those instances the U.S. Treasury yield curve served as an early warning signal. A type of “canary in the coalmine,” if you will. However, I have never seen a yield curve so BOLD in its warning of a coming economic downturn. The severity of the current inversion is so pronounced and massive that I cannot see any other outcome than a very difficult economic recession that is likely now upon us.

When I look at the equity markets, I see an opposite story. I see pundits willing to dismiss the early warning signs noting it is “different this time.” I see the five largest technology stocks out of the S&P 500 accounting for nearly a quarter of the 500-stock index’s market cap. I see valuations of those stocks surpassing 30x earnings with very narrow breadth. I see crypto rising 56.3% year to date, which is the epitome of speculative activity. I see the “experts” preaching that the bear market has died at the same time as M2 (M2 is a measure of the U.S. money stock that includes M1 (currency and coins held by the non-bank public, checkable deposits, and travelers' checks) plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds.) is being drained out of the markets at the fastest pace ever. Finally, I see what appears to be a major collapse in prices of regional banks. When banks are damaged, they don’t lend. If they don’t lend, then capital becomes unavailable to businesses and individuals. They become the transmission mechanism of the Fed’s desire to starve demand for goods and services.

What does the best evidence tell us about the future of the economy? Is the shape of the yield curve still the best indicator of the health of the economy? Could it be different this time? Courtesy of Bank of America, here are some “fun facts” about the current ultra inversion of the U.S. Treasury yield curve:

1. The yield curve has been inverted for over six months. The last time that happened was in 1981.
2. In the past 100 years the current 170bps (basis points) of inversion in the 3-month vs 10-year (3m10yr) yield curve has been exceeded on just 125 days. See chart below:

   

   Source: Bank of America Global Research | Past performance is not indicative of future results.

3. Ten recessions in the U.S. since 1957; each was preceded by tight monetary policy and inversion of the 3m10yr and/or 2yr10yr curve.

4. On average, a U.S. recession has started six months after inversion of the 3m10yr curve and 11 months after the 2yr10yr curve.
   1. In this cycle, the 3m10yr inverted in November 2022, so using the timeline above, the recession should have begun in April 2023 (last month). The 2yr10yr inverted in July 2022, which projects a recession will begin in May 2023 (this month).
5. Inverted yield curves signal recession, but once the recession begins the yield curve immediately steepens as markets discount the Fed’s policy response to a recession. The 2yr10yr peaked inversion at -108bps in April.
6. The 2yr10yr curve has STEEPENED 60bps since March 8 (Silicon Valley Bank collapse) but remains around 54bp inverted. In contrast the 3mo10yr curve has barely steepened. If the 3m10yr curve steepens in the next few weeks that would corroborate a recession now.
7. The speed of the yield curve steepening was quick in disinflationary cycles (1990s–2020). It was much slower in inflationary cycles (1970s–1980s). If a recession is imminent, the ongoing inversion of the 2yr10yr (rather than positively sloped) strongly suggests this is an inflationary cycle and fits with “sell the last rate hike.”

Other Recession Now Signals

• Oil is struggling as demand is waning. OPEC (Organization of the Petroleum Exporting Countries) is cutting supply to balance the market.
• Manufacturing is slowing — ISM (Institute for Supply Management) index is at 46 (contraction level).
• Housing prices are falling across many developed markets.
• Credit is becoming scarce as liquidity dries up. Lending standards to small businesses at tightest since December 2012. Banking crises will likely constrict it more. The growth in M2 money supply (-4.1%) is the greatest amount negative since 1933.
• Regional banks are failing. Depositors are abandoning these banks in favor of money markets which have ballooned to a record $5.3 trillion.
• U.S. government has a debt ceiling problem which could result in a 2011 moment when U.S. debt was downgraded by S&P. The cost to insure U.S. government debt against default (Collateral Default Swaps) for the next year is at RECORD highs. The market perceives a huge amount of risk and volatility.

We realize that nothing is certain in the financial world. I can say, however, that when the canary is near death, we seek shelter and protection. Add to that a “U.S. debt ceiling debate,” the banking system wobble and the narrowness in equity leadership, we believe that gains will be hard to come by unless you are a short seller until deep into the recession.

REMEMBER:

• Bond markets begin to heal generally before equity markets. The Fed Fund futures are indicating that the Fed’s first cut of rates will likely come in the 3^rd quarter of 2023. People hope for a pause, then a cut.
• Financial conditions will have to slow precipitously to cause the Fed to cut rates.
• Be careful what you ask for. Pivot equals pain!
• With the first rate HIKE, the equity markets lose on average 23.5% over the next 195 trading days before bottoming.

Source: Strategas | Past performance is not indicative of future results.

The moral to this story is that the significant weight of the evidence — which has been a reliable indication of what is to come — points squarely at recession. Credit and equities get punished in recessions. We don’t suggest market timing, but we believe you should consider tilting your asset allocation defensive with high quality companies that have defensible profit margins.

CRN: 2023-0502-10861 R