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The yield curve is closely watched by the market and policymakers due to its record as a recession predictor, having inverted before each of the last seven recessions, typically 12-24 months in advance. Timelier still, a dis-inversion of the yield curve often precedes a recession within 12 months, occurring over 50% of the time. With the 2Y vs 10Y yield curve dis-inverting last month and the Fed implementing a jumbo 0.50% rate cut, should investors start worrying about imminent recession, or conversely does it point to a better environment in the future? The truth is either scenario is possible — and investors can make money anyway.
Firstly, remember what the yield curve tells us. It plots the yields of government bonds by maturity. Typically, shorter-term bonds are more sensitive to central bank guidance on near-term rates, while long-dated yields reflect market expectations of average rates over the long run. These longer-term rates are therefore more reflective of the ‘neutral’ rate, where policy is judged to be neither stimulatory nor restrictive. In this way, by comparing the yields over the short and long term, the yield curve signals whether policy is tight or loose.
In normal times, the yield curve should be modestly upward sloping, reflecting the neutral rate plus a term premium for the uncertainty of lending over a longer period. An inverted yield curve is unusual and signals that lenders can earn more by lending over the short-term rather than the long-term. An inversion typically arises when central banks tighten policy. The deeper the inversion the tighter policy is deemed to be, creating a stronger headwind to growth. This tightening eventually reduces economic activity. Dis-inversions, which often precede recessions, are closely linked to rate-cuts, as these are typically implemented in response to economic weakness. This explains why yield curve inversion and dis-inversion have such a close link with recession.
So, what does the recent inverting and dis-inverting yield curve tell us? Very simply, it is saying that policy makers are beginning to adjust policy and stimulate the economy once more. It is a signal that policy is loosening its grip on the economy, not necessarily a harbinger of doom.
In any case, this cycle has been unusual for all sorts of reasons. Today, rather than responding to a weak economy as it has done historically, the Federal Reserve (Fed) is cutting rates while real growth is running at trend of 2% and inflation remains above target at 2.5%. The Fed views this move as pre-emptive and necessary to avoid recession given the current elevated risks.
If a yield curve dis-inversion can signal both a recession and a recovery, what should investors do? Despite the uncertainty, positioning for a steepening has been a profitable trade historically, with the yield curve typically steepening on average more than economists and the market expect.
There are two reasons for this. First, the market has tended to underestimate the degree and pace to which the Fed cuts rates, which drives an outperformance of short-dated yields. This is exactly what we have witnessed this year, with many surprised by the speed at which the market priced in over 2% in rate cuts. Second, rate cutting cycles tend to be shorter than the market expects. The average Fed rate cutting cycle has lasted just 10 months, and only once since the 1950s (in 1990-92) has one extended beyond two years. This is despite the Fed often communicating a 2-3 year rate-cutting horizon.
In other words, cutting cycles are typically deeper and shorter than investors expect. This has historically been a function of a crisis ensuing forcing a rapid and deep cycle, driving down short-dated yields, or because the economy improves sooner than expected, causing long-dated bond yields to price in a quicker rise in the future, or both.
It is the dual payoff which makes positioning for a steeper yield curve attractive, given it is likely to produce profit in multiple scenarios.
As discussed earlier, an inversion and subsequent dis-inversion is not a guarantee that recession is imminent. Yet whether the economy stumbles or soars, bond yields fall or rise, betting on a steeper yield curve has often paid off. We believe that this time will be no different.
