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Inversion of the yield curve: what it meant in the past and what to expect in the future

Updated: Dec 4, 2023

WHAT DOES IT MEAN AND HOW TO IDENTIFY IT



A yield curve is a line that plots yields (interest rates) of bonds of the same credit quality but differing maturities. The most closely watched yield curve is that for U.S. Treasury debt. An inverted yield curve means that long-term interest rates are less than short-term interest rates. With an inverted yield curve, the yield decreases the farther away the maturity date is. It is a very strong indicator because in the past 7/7 predicted a recession. For example, the U.S. Treasury publishes daily Treasury bill and bond yields that can be charted as a curve.


The yield curve reflects the market view of the economy, especially when it refers to inflation. Investors who think inflation will rise so they demand higher yield to offset its effect. Since inflation drifts from a strong economic growth, an upward yield curve means that investors have good expectations. In reverse, an inverted yield curve reflects investors’ expectations for a decline in longer-term interest rates as a result of a deteriorating economic performance.


There are a lot of yield curves but maybe the most popular is the 2 years and 10 years. However, according to the Fed, the spread between 10-year and three-month yields is the best at predicting recessions. Despite the Fed’s preferences, the inversion of the curve 10/2 has always anticipated recessions. In the past, when divergences between others spread, they were always corrected.



THE HISTORY OF INVERSIONS




In the United States, the yield curve has inverted several times over the past five decades, with each inversion being followed by a recession. Starting in 1976, the yield curve inverted for the first time in 1978, preceding the recession of 1980. The yield curve inverted again in 1989, preceding the recession of 1990-1991. In 1998, the yield curve inverted slightly before the dot-com bubble burst in 2000. The yield curve inverted again in February 2006, preceding the Great Recession of 2008.


The most recent inversion occurred in 2019, preceding a brief recession in the wake of the COVID-19 pandemic, but with the yield curve inverting again in recent months, many analysts are concerned that another recession may be on the horizon.


Looking further back in time, each of the recessions since 1950 were preceded by periods when the yield on the 2-year note exceeded the yield on the 10-year bond. There was one case where no recession followed, in 1965 and 1966, but with that one exception, every dip into a negative yield spread in the past was followed by a recession within a year. During the 1930s and 1940s, short-term interest rates were kept artificially low because of the Great Depression in the 1930s and World War II in the 1940s. If you go back to the 1920s, however, you can see that both the 1920-1921 recession and the 1929-1932 Depression were preceded by yield-curve inversions. Moreover, seven of the nine bear markets since 1950 were preceded by a yield inversion. The 1962 Steel Crisis and the 1987 Stock Market Crash were not preceded by a yield inversion, and no bear market followed the 1969 inversion. Given the evidence, the yield inversion between the 2-year note and 10-year bond is not a perfect indicator of future recessions and bear markets. However, over 80% of the time it does prove to be an accurate indicator.



DIFFERENCES BETWEEN USA AND EUROPE


Now we will analyze the current development of the inversion of yields from long to short maturities and from this point of view we will try to compare FED’s and ECB’s situations.

Let's take a look at the 10 years – 2 years maturities:


Spread maturity USA: (Source: Tradingview)




Spread maturity EU: (Source: Tradingview)




Is important to specify that the inversion of the curve implies that the long-term economic prospects are worse than those in the short term.

The economic significance of this event is therefore explained by the expectations of the markets on the inflation dynamics: if the markets expect a reduction in rates in the future (e.g. 10 years from now), and consequently an expected value of inflation over the same period on the target level of 2%, rational investors are now buying 10Y bonds as their prices today are lower than expected 10 years hence. On the other hand, we have short-term rates driven by the restrictive monetary policies under way by the FED and the ECB.


It is immediately clear that the spread in the USA has been in negative territory for around 7 months, while in Europe for only 3 months and with a much more contained spread. This is a first graphic explanation of why the recession is a debated issue mainly in the US and still quite far from the eurozone. We believe the main cause is linked to the fact that the board led by Cristine Lagarde is still behind in terms of increases in the level of refinancing rates which today fluctuate around 3.5%, compared to a FED which has proved to be much more aggressive from this point of view, reaching the 4.75% level as the cost of the main refinancing operations in the meeting held on February 1st.


The central theme in the inversion of the maturities curve is certainly the abatement of the inflationary spiral, which has reached its maximum both in the USA (about 9%, from the reading of the month of June) and in the EU (about 10.6%, from the reading of the month of October), to then report significant drops in both cases, we are currently at 6.5% in the USA and 8.5% in the EU.


Reassuring data, which tends to hide from us the fact that the "core" data, the figures that eludes goods subject to high volatility (food and energy), remains high in both the US and the EU. In this regard, however, it must always be remembered that this sharp decrease in inflation is also due in part to the collapse in the prices of raw materials which manifests an indirect influence on the production prices of companies and therefore on the prices and consumption choices of individuals, however this important effect on the price list of the products does not manifest itself immediately and by adopting a Keynes-like hypothesis of sticky prices in the short term, it is not trivial and immediate to consider the influence that the decrease in the price of raw materials has on the final prices consumption that take a long time to adjust to changes in production costs.


However, central banks are continuing their "tight" policies making use of conventional and non-conventional instruments, to try to curb demand and indirectly impact global supply curbing the positive dynamics of prices. Therefore, it is premature to formulate hypotheses about a possible recession on both sides to the extent that central banks deem it appropriate to continue with the restrictions in order to efficiently pursue their objectives of maintaining monetary and employment stability (in the particular case of the dual mandate for the FED ). It will be important to evaluate the trend of the data, especially in the coming months the central bankers deem it appropriate to keep an eye on the dynamics of wages which better than any other indicator outline the potential purchasing power of individuals.



MARKET SENTIMENT 2023, WHAT TO EXPECT?


Obviously in this part we will not make predictions with the presumption of wanting to predict the future. The reality is that no one is able to predict market trends in the short and medium term, a different story for the long term, where the historian up to now has always confirmed a bullish view of the markets. I recommend this reading.


What we will do today therefore, having eliminated the possibility of making forecasts, will be to try, thanks to the study of some graphs that trace economically relevant macro data, to compose the broadest possible vision of the situation and consequently, looking at the historian, try to imagine how current data can influence the future of the markets with a probabilistic approach. The great premise of this part of the article is that, given the large amount of information already present, I will try to be as concise and clear as possible, necessarily having to eliminate some information that would otherwise make the reading too long and demanding.


Once the preambles are over, let's start immediately with the LEI indicator. If you have no idea what this indicator is, I recommend reading this page.


In short we are talking about an indicator that represents a set of 10 macroeconomic indicators such as average weekly hours worked by manufacturing workers, average number of initial applications for unemployment insurance, the volume of new orders for capital goods, the spread between long and short interest rates and others. All these indicators put together give us an idea of the state of health of the economy to which we refer to, in this case we are obviously talking about the American one.


How can this indicator practically help us in our process of creating a basket of possibilities for the near future? easy, let's compare it with the trend of % change real GDP and see if there is a correlation.





As can be easily seen, there is a direct correlation between the two lines. It is important to underline how the blue line (% change LEI) anticipates the gray line (% real GDP) both in the 2001 and in the 2008 crisis. A somewhat different story for the 2020 crisis which we can consider as an anomalous crisis, due to a so-called black swan, which confirms that yes, this indicator can be useful in forecasting a recession, but as previously mentioned it is impossible to be certain when it comes to financial market forecasts.


Returning to the indicator with the latest data, we see how the Blue line is experiencing a sharp deceleration reaching levels that have always indicated a recession in the near future. As mentioned, this does not indicate a safe recession in the near future, but it considerably increases the chances.


To confirm this theory, let's now study the performance of the various asset classes, bearing in mind that in a normal economic cycle after an expansion, the first asset class to fall are bonds, this is because investors try to hedge and keep profits made during the bear market. After that it will be up to equities to see a decline and lastly raw materials.




Thanks to this graph, we can see how bonds were actually the first asset class to fall, already with a first boost in the 2020 crisis and with a second boost, the one that interests us most in this study in 2022.


Equities, which have been suffering from the rise in interest rates for a year now, a different story in this case should be done for Europe, which after having served a large-scale energy crisis, has seen the realization of a situation less critical than expected.


Last, to conclude, the commodities. The driving asset class for all of 2020 and 2021 is starting to see the first weaknesses with oil now very far from the boulders of March and June 2022 and a gas price that is also strongly downwards.


In conclusion, many macroeconomic indicators show us how a recession is possible in the next period, but this should not give us the presumption of thinking we have the truth in our pocket, the market with all its rules takes into account an immensity of variables to which we cannot refer, our task will only be to try to have an ever clearer picture of the current situation in order to be able to create the largest possible statistical advantage, in order to then implement our strategies when certain scenarios, having said that, thanks for your time and see you next time.






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