Yawning at the Yield Curve

Who will be caught falling asleep at the wheel during the longest yield curve inversion in modern US history?

May 05, 2024

Highlights

We have to work hard to overcome inherent cognitive biases and noise that exist within decision-making.
What is it going to take for the curve to normalize and steepen back into positive territory? At some point, there will be a mean reversion of the US 10s-2s yield curve.
If there is nothing wrong with the banking system, financial markets, or the economy, then why would the Fed cut rates from here?

Happy Weekend!

Colors of deep green currently fill the foliage of the trees that surround my backyard. A slight breeze is causing the small green leaves to marginally sway back and forth. Here in Atlanta, we are blessed to get four real seasons. Sorry Florida. “WTF why is this guy rambling about seasons”~ a random reader probably. The last time I published around the new year 2024, everything was grey, trees barren, cold rain steadily falling, and the humid air was also filled with unpleasantly cold temperatures. Now that summer is back, the mental distortion of time makes those winter conditions seem like the distant past.

There has been a small gap between publications because I have taken some time to reflect on how I can be a better writer and to just study. One of the books that I read recently was called Noise, by Daniel Kahneman. While reading, I continued to identify situations where I was falling into various traps of judgment, noise, and bias. These traps were impacting my decision-making and even my written work that I was sharing with readers on this platform. The first step to improving is at least acknowledging that bias and noise exist. From here, actions forward can be taken. Below is one of my favorite quotes from the book.

“Cognitive biases and other emotional or motivated distortions of thinking are often used as explanations for poor judgments. Analysts invoke overconfidence, anchoring, loss aversion, availability bias, and other biases to explain decisions that turned out badly. Such bias-based explanations are satisfying because the human mind craves causal explanations. Whenever something goes wrong, we look for a cause and often find it. In many cases, the cause will appear to be a bias” (Pg 369)- Daniel Kahneman.

As an analyst, I fully recognize there were various situations over the last year where I fell victim to anchoring, availability bias, and honestly probably all of the above. Going forward my mind is actively open (not that it wasn’t before), and am more humble from lessons that I have learned as I reflected over the past several years. I highly recommend reading Noise, but first start with Daniel Kahneman’s book, “Thinking, Fast and Slow” (no, I am not getting paid to shill books). May Daniel Kahneman rest in peace.

Not to bother that one triggered reader about the seasons once more, but there have now been eight full turns of the calendar seasons since the first time the yield curve inverted in April & July of 2022. Just like someone reading this text had already forgotten we were even talking about the seasons until I mentioned it at the beginning of the paragraph, who is still thinking of the yield curve inversion after two years of falling into Macro obscurity?

Macro

The US 10s-2s yield curve first inverted in April of 2022, and has been fully inverted since July 5, 2022, which is approximately 670 consecutive days. What is it going to take for the curve to normalize and steepen back into positive territory? The mean reversion of the curve is what we are here to discuss today. This conversation serves to contemplate thoughts running around my head.

Here is the longest consecutive day streak the yield curve has been inverted in modern US history. Before anyone automatically assumes that this publication is a “recession call”, I will put that thought to rest by saying this is not a recession call. We are just discussing a Macro setup. Sorry to disappoint any doomsday readers, and for withdrawing what was lining up to be a solid dose of confirmation bias.

*Source: Tradingview

What is the yield curve?

Generally, the yield curve refers to the US 10s-2s spread. This is a spread or comparison between the US 10-YR bond yield vs. the US 2-YR bond yield. When the US 2-YR yield is greater than the US 10-YR yield then the curve is inverted.

For example, if the US 10-YR yield is 4.51% and the 2-YR yield is 4.82% then 4.51%-4.82%= -0.31 (inverted).
For example, if the US 10-YR yield is 4.82% and the 2-YR yield is 4.51% then 4.82%-4.51%= +0.31 (Steep).

The 10-YR yield is usually controlled by the market’s economic growth and inflation expectations, while the 2-YR yield is ordinarily controlled by the market’s anticipation of US Fed policy.

Why is this important?

Again, not to go down this rabbit hole today, but the yield curve is historically the best leading indicator for a US recession with a near-perfect batting average, and the amount of time of the inversion does not matter within that context. The length of the current yield curve inversion speaks to the high levels of bond volatility and the irregularity that persists in the bond market. However, this is not why we are talking about the curve today.

At some point, there will be a mean reversion of the US yield curve back into positive territory, and this is what I find interesting. As mentioned above, my view is that general market participants have been lulled to sleep by this historic inversion. Think of everything that has happened in the world since July 5, 2022. Think about what has happened in one’s personal life during that time. Think about what was being done on that exact day. Similar to my comment on the seasons earlier, feels like forever ago huh?

We live in a fast-paced world with high-frequency data that is constantly inundating our minds. The inverted yield curve after pretty much two years is yesterday’s news at this point, but I think that is why it is worth talking about once again.

For some historical context (dating back to 1978), the yield curve was inverted:

Approximately 219 consecutive days between August 16, 2006 and March 21, 2007.
Approximately 321 consecutive days between February 2, 2000 and December 27, 2000.
Approximately 179 consecutive days between January 4, 1989 and June 30, 1989.
Approximately 122 consecutive days between January 20, 1982 and May 20, 1982.
Approximately 407 consecutive days between September 12, 1980 and October 26, 1981.
Approximately 502 consecutive days between August 17, 1978 and May 2, 1980.

*Source: Federal Reserve Bank of St. Louis; shaded areas indicate US recessions.

What will the mean reversion and steepening of the curve look like?

Two probabilistic outcomes come to mind. There is a third, but I do not want to waste time talking about it today because my view is that it is the least likely outcome, but I am mentioning it to avoid falling into the trap of excessive coherence (see resources section for the description from Noise). Note, that the outcomes below are not listed in any particular order.

First outcome: Economic growth remains steady, there is no dangerous surge in unemployment, and inflation continues to accelerate (such is the current trend but this could always change). Perhaps inflation could trend towards 4% by the end of the year. Consensus expectations for CPI are currently near 2.6% by year-end. Mathematically, CPI will have a difficult time cracking 3% by year-end all else being equal. So, 4% CPI by the end of the year would be a big problem for most market participants.

Under these conditions, the bond market at the long end of the curve (10-YR yield) will move with respect to the incoming inflation data and inflation expectations. Going back to hypotheticals, let’s use the spread between the 10-YR yield and the latest CPI report from March of 3.5%. For the 10-YR yield, we will use a rate of 4.7% because that rate was the fallout from the reaction to the March CPI data and other “stronger” economic data points throughout April. The spread was +1.2% (yield vs. inflation).

Now, in the real world, it is important to acknowledge that +50bps of additional CPI by year-end does not translate to a specific basis point movement for the 10-YR yield. However, assuming that the +1.2% spread discussed above is maintained and is desired by bond investors (yield vs. inflation), then we could get to a 10-YR yield of approximately 5.2%. This is +70bps higher than where the 10-YR closed on Friday at 4.51%. Who in the market and specifically those involved with commercial real estate are positioned for a +5% UST yield?

Why would the Fed be cutting rates under the economic conditions mentioned above? If there is nothing wrong with the banking system, financial markets, or the economy, then why would the Fed cut rates from here?

That being said, let’s say the Fed leaves the policy rate unchanged despite the continued acceleration of inflation because monetary policy is restrictive enough and works at a lag. This means that we would have a 2-YR yield of approximately 5%-5.25% (unless the bond market starts raising rates for the fed, which is another can of worms).

With a 10-YR yield of 5.2% and a 2-YR yield of 5%-5.25%, the yield curve could steepen from -31bps (inverted) today to -5bps (inverted but less) to +20bps (steep). Both of which are steeper. However, even then, that is barely a mean reversion for the yield curve (+26bps to +51bps higher). What will it take for the yield curve to normalize?

Second outcome: The economy starts tanking and the financial markets are in distress. Growth is slowing precipitously, and inflation starts to decelerate even overshooting the Feds’s 2% target to the downside. Under these conditions, the Fed could be aggressively cutting rates to stimulate the economy.

Now we go into hypotheticals. For example, maybe the Fed cuts the fed funds rate from 5.25%-5.50% (current) to 3% in 6 months. The 2-YR yield potentially falls to 3%, but is also falling faster than the 10-YR yield as the market anticipates more rate cuts. At the same time, since both growth and inflation are slowing, perhaps the 10-YR yield falls to 3.2%-3.5%. Under these circumstances, the yield curve would be +0.2% to +0.5% (steep).

Third outcome: Not falling into excessive coherence. For this scenario, let’s assume that economic growth remains steady, and employment stays strong. Additionally, economic growth is rebounding around the world in big places such as China and Europe, so globally, the economy is also in a better place than in the past two years.

Meanwhile (back to hypotheticals), into year-end and early next year, inflation falls towards 2% just like most people NEED to happen (extra emphasis on their need). The economic rebounds in China and Europe prove to have no impact on US inflation. Given the progress being made on the inflation front the Fed decides to cut the policy rate to 4%.

The curve steepens and moves into positive territory as the short end (2-YR yield) falls faster towards the expected terminal rate than the long end (10-YR yield). As mentioned, growth is still steady, so the 10-YR does not fall as fast.

Despite the strong economy and labor market, these rate cuts are not stimulative and have no impact/ do not cause more inflation going forward from that point in time (emphasis on hypothetical). Everything turns out to be just fine. The US markets continue moving higher and the economy continues to grow steadily while policy makers actually were able to achieve price stability.

There are already some inherent flaws with the third outcome as far as what that yield curve inversion might look like in comparison to the other examples used above, but I have gone on long enough, so let’s discuss this in the comments section.

Conclusion

Is the market ready and positioned properly for a 5.2% 10-YR yield?
Can the US bond market even get to a +5% 10-YR yield without the economy slowing?
Will there be credit issues with a 10-YR yield above +5%? As that happens will those issues slow the economy, which could take rates lower once more?
If rates move lower because growth and inflation are slowing, does that short-term not act as a stimulative towards growth and inflation thus eventually leading to higher long rates again?
Why would the Fed cut rates from here if there is nothing wrong with the banking system, financial markets, or the economy?

There are a couple of ways to play the yield curve through fixed-income ETF strategies run by Nancy Davis and Quadratic Capital. The ETF, IVOL, can be used to be long a yield curve steepening, while BNDD can be used to be long a yield curve that is flattening/ inverting. I will also include a link to Quadratic Capital in the resources. She is brilliant and knows the plumbing of fixed-income markets as if it were second nature. See her interview with Keith McCullough (Hedgeye Risk Management) in the resources section to learn more about Nancy Davis. That interview also provided me with some extra inspiration to write this piece.

Quite the conundrum exists in the bond market. If long rates go too high too fast, then growth slows and inflation slows on the margin. Following, rates fall and is stimulative short-term then inflation starts to bottom again and even re-accelerates. Eventually, this takes long rates higher once again. The cycle repeats. How does the market get out? What will it take for the yield curve to normalize?

Best of Luck,

Aaron David Garfinkel

Resources

Macro Optics (Link Here)
Noise by Daniel Kahneman (Link Here)
Thinking, Fast and Slow (Link Here)
Yield Curve (Tradingview)
Excessive Coherence- Causes people to distort or ignore information that does not fit a preexisting or emerging story. People can reduce this by breaking down a judgment into a series of smaller tasks.
Keith McCullough Interviews Nancy Davis (Link Here)
Quadratic Capital (Link Here)

Take A Breath.....Annnnnd Think, Weekend Reading

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