What the inverted yield curve says about the next recession

By Aaron Brown.A yield curve inversion, when rates for two-year US Treasury notes rise above those for 10-year notes, has preceded every recession since the 1960s. The first clear inversion in 15 years happened in July 2022, although there were brief and shallow inversions in August 2019 and April 2022..All that is old news. What's happened since July is the inversion, unlike all others since the early 1980s, has become deeper so that the two-year yield is now almost 80 basis points, or 0.8 percentage point, higher than the 10-year yield. This inversion is only exceeded by the ones of 1978 to 1982, when the Federal Reserve chairman Paul Volcker was ramping up benchmark rates to double digits to reverse high inflation at the cost of two long and deep recessions. Investors are naturally now asking whether the next recession will be longer and deeper than any of the previous 40 years?.___STEADY_PAYWALL___.To answer the question, we must begin by distinguishing monetary inversions from real economy inversions. Monetary inversions are the result of Fed rate increases. Those push up the cost of short-term borrowing but also reduce the expected amount of future inflation, which can bring down long-term yields. The subsequent recession is caused by Fed tightening, the inversion is only a signal of that tightening..Real economy inversions are more complex. They reflect market opinions that there will be a recession. In recessions consumers and companies try to pay down debt rather than take on new debt. Yet some consumers are forced to borrow to make ends meet, and some companies are forced to borrow to finance inventory that cannot be sold and cover short-term bills. Investors prefer to lend to entities that don't need the money, so they charge high rates for these shaky short-term loans..At the same time, there are few good investments in recessions. Investors generally take money out of stocks and other risky investments, and are willing to accept low returns in safe, long-term fixed income investments. But there is little demand for long-term funds because businesses are not expanding and people are not buying homes aggressively. Lots of willing lenders and few long-term borrowers sends long-term rates down..Of course, the real economy is messier than these simple stories, and there are many elaborations and nuances to inversions and the economy. The key point for today is that both of these mechanisms are self-limiting, which is why inversions are usually mild. In a monetary inversion, people expect the Fed to eventually slash rates if a recession occurs, so long-term rates don't drop much below short-term rates. In a real economy inversion, investors expect the recession to clear out the economic deadwood and reduce leverage through a combination of repayment and default, and for new attractive risky long-term investments to appear. Once that happens, a normal, upward sloping yield curve should return..If the current inversion continues to increase, there are two basic explanations: monetary and real economy. In the 1978 – 1982 period, the market correctly believed that Volcker was willing to keep rates high even in a recession and that it would take several years to squeeze inflation out of the economy. If the current inversion is mostly monetary, it suggests the market believes current Fed chair Jerome Powell is willing to keep rates high even in a recession, and that it could take four or five years to correct the vast expansion in federal debt and money supply, plus the bubbles created during the longest bull market in history..On the other hand, if real economic calculations are causing the current inversion, its increasing size could mean investors do not expect a productive recession in which creative destruction restores the economy to a condition to support the next bull market. Debt will be reduced not by repayment or default, but by government forgiveness and subsidies. Markets will clear not by prices falling, but by price controls or government borrowing..In the monetary scenario, increasing inversion suggests current problems are worse than most people think, and the Fed has the ability and willingness to solve them. In the real economy scenario, it suggests the problems are in the future, and political leaders have the ability and willingness to create them..So, is our current inversion primarily monetary or real? One clue is how much the Fed has raised rates. In the 1978 – 1980 inversion, the average federal funds rate during the time of inversion was 194 basis point higher than the average of the previous two years. But in the next four inversions, the average during the period of inversion was substantially lower than average rate from the prior two years. This suggests that the 1978 – 1980 inversion was monetary, while the next four inversions were economic..In the 2005 – 2007 inversion, the average fed funds rate was 122 basis points higher than the average of the prior two years, and in the current inversion it has so far been 124 basis points higher. This suggests these last two inversions are monetary, but not (yet) as extreme as the Volcker Shock..But if the inversion reflects investor predictions of the future, we should see it in the real return of the S&P 500 Index during the period of inversion. So far stocks have lost 14% to inflation over the current inversion. The only other inversion with a negative S&P 500 real return was the 1980 – 1982 inversion, with a real loss of 18%. This suggests that those two inversions were real. So, the current inversion has strong monetary and real components..Before over-reacting and predicting disaster, remember that the current inversion is only 77 basis points, compared with the 241-basis-point peak in 1978 – 1980 and 170 basis points in 1980 – 1982. Plus, Fed rate increases of 124 basis points are well below the 194 basis points of 1978 – 1980, and the stock market decline of 14% is not as severe as the 18% of 1980 – 1982. So, while the signs are ominous, they're not yet at a level to expect Volcker Shock conditions. We will likely have a recession, and it may be more painful than the previous four, but as of now it seems likely to be more similar to those last four than to the disruption that ended the 1970s inflation express..Read more:.Investors overseeing $5 trillion are betting that an economic recession can be avoidedFed's yield-curve barometer starts flashing recession risk"Dr Doom" Roubini expects a 'long, ugly' recession and stocks sinking 40%.© 2022 Bloomberg L.P.

What the inverted yield curve says about the next recession

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