US Treasuries with two years to maturity have this week moved in price to the extent that the return on that investment pays the holder a greater return than the equivalent Treasury, which is 10 years from maturing. This inversion of bond yields is a significant event because the standard principles of economics dictate that the return from an investment increases with the length of time the investors funds are placed with the third party. This compensates the investor for the ‘opportunity cost’ of losing access to their funds for longer. It also compensates the investor for the extra time they are exposed to the risk of the issuer defaulting.
Over a longer-term time scale, yield curve inversions are a relatively rare occurrence. Looking at the current markets, concerned investors are noting we’ve seen two inversions in the space of one week.
On Wednesday 14th August, the two year US Treasury (UST 2yr) and 10 year US Treasury (UST 10 yr) experienced inverted yields. As per the below chart, the spread moved into negative territory half-way through the morning session.
The inversion on 14th August was the first UST 2yr / UST 10 yr inversion for seven years. On Wednesday 21st August, it happened again. Patti Domm, of CNBC noted:
“Soon after the Fed’s 2 pm ET release of its minutes, the curve between the 2-year note and the 10-year note flattened. It then briefly inverted later Wednesday afternoon, with the 2-year yield rising above the 10-year yield.”
The counterintuitive nature of an inversion has a significance that extends beyond economic theory. In fact, it’s seen as one of the most important and reliable indicators of an economic recession.
There is a very strong correlation between bond inversions and recessions.
Bloomberg data shows that following yield curve inversions in 1989, in 2000 and in 2006, there were recessions, starting in 1990, 2001 and 2008.
There are several arguments that challenge the inversion-recession argument. A stopped clock is correct twice a day. Some argue the typical lag between inversion and subsequent recession is too long to confirm causality. There are also instances where the inversion wasn’t followed by a recession. And of course, there is the often used, ‘this time it’s different’.
CNBC reports that Credit Suisse analysts have shared the opinion that:
“Even when it does predict a recession, it is, on average, 22 months early.”
The debate about the reliability of the indicator will continue. The first note to make is to stress that whilst the UST 2yr and UST 10yr yields are the most keenly observed, different dated bonds are also closely monitored. Some analysts, for example, will argue the UST 3month / UST 10yr is a more useful indicator. The Bloomberg chart above actually includes this metric on the same graph. The two different metrics can of course be used in conjunction and checked to see if they support each other.
There is a mass of statistical data that can be mined and filleted in a multitude of ways and ‘reliability’ and ‘strength’ of indicator can be adjusted to personal taste. Going with the UST 2yr and UST 10yr spread has value for various reasons. The most important being that it is the most widely used. If President Trump and US Fed chairman Jerome Powell are discussing the 2/10yr spread then investors need to be up to speed on it.
Jerome Powell, chair of the US Federal Reserve, is currently busy with colleagues at the Fed’s Jackson Hole Symposium. They will share an update of their approach on Friday (10:00 EST). Speaking to CNBC, Michael Gapen, chief US economist at Barlcays said:
“If midcycle adjustment is not in the Jackson Hole speech, people will interpret that as opening the door for more cuts as opposed to two or three.”
Powell might take some of the pressure off himself if he does signal a more dovish monetary policy. President Trump has for some time been vociferously signalling the Fed might be waiting too long to cut interest rates. The financial markets might also be moving to that viewpoint.
Powell is proving to be anything but a ‘yes man’. To date, his preference has been to adjust Fed policy according to hard data rather than higher level strategic aims, which truth be told, largely emanate from the White House.
Jon Hill at BMO explains the situation facing Powell:
“If the FOMC doesn’t indicate strong urgency to cut very aggressively, we’re back to that world of slowing growth, weak inflation and a Fed that’s running the risk of not providing as much support as needed, which is the recipe for yield curve inversion.”
Hill goes on to explain the other side of the argument:
“However, some of the economic data has shown green shoots… and there are concerns of financial stability, which are reasonable. Cutting this early in the cycle before economic data turns could lead to excessive risk taking.”
The hurdle that the US Fed needs to get over is that interest rates are so low that the US government can borrow at near to zero cost. A German government auction on Wednesday saw bonds sold at negative yields.
Powell will be aware that the US government has the ability to draw down ‘free money’ and instigate expansive fiscal policy. To some extent, the Fed is finding itself forced into a corner and taking on the role of the last authority responsible for keeping a lid on inflation, but it is a role it can’t turn down.
Friday will be a moment when the market takes on board the ‘guidance’ of Jerome Powell. Analysts can predict with some certainty that the reaction will see billions of dollars of value added or wiped off financial assets. Whether the guidance actually offers much light on the future direction of policy is another question.