Deep Dive: The inverted Treasury yield curve – Is it different this time?

 Deep Dive: The inverted Treasury yield curve – Is it different this time?


On April 1, 2022, the US 10-year Treasury note’s yield dipped below that of the 2-year Treasury, inverting that part of the curve for the first time since 2019. Every time since 1978 that the 2/10 curve inverted, recessions eventually followed.

But they didn’t follow immediately, and some analysts are saying that perhaps “it’s different this time,” that a recession may not follow at all. Meanwhile, the curve flipped back to a positive slope a few days later.

There are many factors in play today that are undeniably different than during past inverted-curve periods. A small sampling: the war in Ukraine, rampant inflation, rising interest rates and quantitative easing / tightening.

It is not clear that taken collectively, these differences will mean the US will dodge a recession following an inverted 2/10 Treasury curve for the first time in more than 40 years. It is equally unclear what the investing landscape will look like between now and when a recession hits – if it hits. It is worth exploring.

Looking back
A look back at previous 2/10 curve inversions since 1978 reveals a pair of consistent characteristics in the period between the first day that the curve inverted and the start of the subsequent recession, what we’ll call the “inversion-recession period.”

First, as mentioned, recessions did not closely follow the initial curve inversion (it’s been over three weeks already this time). Rather, each of the six recessions since 1978 began an average of 15 months after the curve first inverted.

Source: St. Louis Fed

The shortest inversion-recession period was 158 days, before the 2020 recession, while the longest was 1,010 days, ahead of the 2001 recession. And the 1990, 2001 and 2007 recessions were preceded by double-dip inversions, where the curve inverted, righted itself, then inverted again.

Second – and perhaps unexpectedly – during all six inversion-recession periods the equity markets rose (represented here by the S&P 500 Index). And for the inversion-recession periods since the high-yield and leveraged loan market indices began, each of those markets also rose (high-yield is represented by the ICE / BofA US High Yield Index, leveraged loans by the S & P / LSTA Leveraged Loan Index). For further information on this, see “Fridson: High yield returns before and during recessions.”

War in Ukraine
Of the factors present today that may make the April Treasury curve inversion different, the Russian invasion of Ukraine is perhaps most unique. Not since the Second World War has there been a land battle on the European continent of this size and scope, involving virtually every nation in Europe in one way or another, and impacting food, oil & gas and other commodity supplies and prices around the world .

Ukraine’s economy may shrink by 40% by year-end 2022, according to Foreignpolicy.com. But for the economies of the US and Western Europe, acting not as combatants but rather as both suppliers of war material and consumers of Ukrainian and Russian commodities, the war is likely to have a more nuanced effect: defense spending is already ramping higher and commodity prices have been rising.

With the press hypothesizing about a reemerging Cold War, the Ukrainian conflict is renewing US focus on military preparedness, meaning that US military expenditures may rise for years to come. Already US President Biden has proposed a roughly 4% increase in defense spending in this year’s budget to counter security threats from the other superpowers.

For consumers and corporate earnings, the ultimate impact of price hikes generated by uncertainty to oil and gas supplies, destruction of Ukrainian crop production and the possible weaponizing of other commodities by Russia remains to be seen. They may contribute to the rise in interest rates as central banks attempt to slow inflation, which, as discussed below, could reduce multiple M&A, harm investable markets and hinder the economy.

On the other side of the ledger, increased defense industry employment and earnings could offset some of the negatives. Whether it will be enough to stave off a recession is unclear.

Inflation factor
Inflation, now at its highest point in 40 years, is also significantly different this time. Following its descent from the 1980 peak, it clawed back to 5.4% in 1990. Then in 1996, Fed chairman Ben Bernanke set a 2% inflation target and we had been in that zip code ever since. Until now.

Inflation ran at 8.5% over the 12 months ended March 30. While that is more than four times Bernanke’s target, if consumers can bear it – and consumers are roughly 70% of the economy – inflation may, at least for now, have little net impact on the US economy’s health.

One guide to what consumers can handle is Real Disposable Personal Income (RDPI) per capita, or Disposable Personal Income per capita adjusted for inflation. If disposable income keeps up with inflation, then so might consumers, and therefore corporate earnings, and so then perhaps stock prices as well.

Source: St. Louis Fed

Since 1978, RDPI per capita rose in every inversion-recession period. As the Treasury yield curve just recently inverted, we don’t know if things will be different during the current period. But we do know that RDPI per capita has declined steadily since July 2021.

Even though wages have been rising recently, they aren’t keeping pace with inflation. Consumers are falling behind. That is different than in past inversion-recession periods, and in a way that does not support the economy.

Interest rates
On the other hand, rising inflation expectations might boost the economy, at least for a while. Economist Irving Fisher provides the theoretical basis for this. In 1930, he postulated that the real interest rate equals the nominal interest rate minus the expected inflation rate. This means that raising expected inflation reduces the real interest rate. Since it is well-settled that low interest rates spur the economy, the economy should improve as inflation expectations rise.

But the current high level of inflation creates uncertainty about its effectiveness as a stimulant. Christina Romer, former chair of the Council of Economic Advisers, was quoted by the Federal Reserve Bank of Boston as saying in 2011 that “a small increase in expected inflation could be helpful. It would lower real borrowing costs, and encourage spending on big-ticket items like cars, homes and business equipment. ”

Inflation was 3.2% in 2011, so today’s 8.5% rate is not “small” in comparison. More importantly, plugging the current inflation rate into the Fisher equation yields a negative real interest rate. Negative real rates were not on Fisher’s radar in 1930 (the US was dealing with deflation in the years around 1930, which under the Fisher equation would raise real interest rates). As a result, the current negative-real-rate environment may not be a predictor of rising consumer consumption.

So, whether rising inflation coupled with higher nominal interest rates will, in the short run, help or hurt the economy is, for now, unclear.

Valuations
Interest rates have a direct impact on valuations, as most valuation methodologies use them to discount future cash flows. Lower interest rates make outer-year cash flows worth more, so the steady interest rate downtrend of the past four decades has been a breeze at the back of valuations and lifted merger and acquisition multiples.

Source: St. Louis Fed

Now with the 10-year Treasury more than 225 basis points above its historically low yields during the depths of the pandemic, the interest rate downtrend has been halted. This is definitely different this time.

All things being equal, rising interest rates reduce the value of cashflow-generating assets such as stocks and bonds. Judging by recent LBO transaction multiples, exactly that may be happening.

Rising rates will make the financing of some high-multiple acquisitions prohibitively expensive, and price some high-yield companies out of the debt capital markets. That, in turn, might further reduce multiple acquisition and by extension, hurt equity markets. A reverse “wealth effect” could kick in, slowing consumer spending, lowering corporate earnings and eventually leading to recession.

Unwinding QE
Some believe that quantitative easing made this inverted yield curve decidedly different than the others, distorting or even invalidating the inversion’s recession warning signal. But when the curve inverted in April, there was no QE. The Fed announced in November 2021 that it would slow asset purchases and QE ended completely in early March.

Moreover, Fed Chairman Powell said quantitative tightening might begin by the May Fed meeting. So, not only did the Treasury market have more than four months’ warning that QE was ending, but it was on notice that tightening would soon begin.

It raises the question of how different this inverted curve is from the others. If anything, quantitative tightening might have the effect of enhancing the curve’s positive slope as the Fed competes with corporations for buyers, and so perhaps magnifying the inversion’s signal quality.

The last Fed balance sheet reduction began in October 2017, but the S&P 500 didn’t react negatively to it until one year later. When it finally turned south, as Jeffrey Gundlach of DoubleLine Capital put it in an interview last August with Yahoo Finance, “the stock market had a mini-crash. It actually went into a very compressed bear market in the fourth quarter of 2018. ”

If the curve reversal a few weeks ago was a valid recession warning, it will be interesting to see if a year elapses this time around before QT negatively impacts equity markets. It will be equally interesting to observe if equity weakness impacts consumers and ultimately the economy.

So, is it different this time?
Many investors believe that it is never “different this time,” that what differences there may be between this time and others are not relevant to the outcome. But some factors in 2022 are unequivocally different from anything the markets have encountered in many years.

Markets have not seen a war like the conflict in Ukraine since the 1940s; they have not encountered this degree of inflation since the 1970s; the 10-year Treasury yield had declined steadily since 1981, but that downtrend may have ceased; and quantitative easing may have held long rates in check, although QE has ended.

Leveraged debt investors have taken shelter from rising inflation and interest rates by reallocating from bonds to loans. Time will tell whether the most recent curve inversion is the first false alarm since at least the late 1970s.



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