The Fed Has Lost Control of the Curve
Actually, I'm just being cheeky. The Fed is never in control of the yield curve, especially the long end. It is a great myth that the Fed "sets interest rates." The Fed sets the Fed Funds rate, and sometimes the market for Treasuries reacts to it, and sometimes it doesn't. Right now, the short end through the 1-year bill is being pushed up by Fed policy, but the market is pricing in lower rates beyond that. Behold, the 1-year spike:
Troughy, not frothy. Chart mine; data from US Treasury.
I didn't dwell on it in January's yield curve update because the spike had just formed, and I wasn't sure if it was a bug or a feature. It's a feature. For most every day in January, the 1-year through 5-year curve has been inverted or flat. At the end of trading on January 25, the 1-7 was inverted. As of February 5, the 1-5 spread is -5 bps.
This chart gives you a sense of what's happening over time. The 1-year is the thick red line. As you can see, it has remained relatively stable, while the long end continues to drop, which is what caused the inversion.
So What Does It Mean?
The obvious explanation is that market participants are anticipating Fed tightening through 2019 and then easing beginning a year from now. This aligns with many predictions, including my own, of a US recession coming at the end of this year or the beginning of next.
So Why Should You Care?
The inversion of the 2-10 yield curve has preceded the previous 6 recessions by 6-24 months, usually closer to 6 months. To be clear, this is a symptom, not the cause of recessions, but it seems to be one of the more reliable predictive variables in this respect. The 2-5 is currently inverted, but the 7- and 10-year bonds are holding up, for now. Still, the trend has been for a 2-10 inversion in late Q2 or early Q3 for some time now.
Yield Curve Model and Predictions
I've been maintaining a simple daily regression model of the yield curve since early 2018, focused primarily on the 2-10 spread. The spread peaked on New Year's Eve 2013 and has been declining in a fairly linear fashion since.
Chart mine; data from US Treasury.
The fit here is very tight with an R2 of over 0.9. The model has been predicting a 0.15-0.16 bps/day drop in the spread since mid-2017. The current model prediction is that the 2-10 spread will flatten on July 7, about 4 weeks later than last month's prediction, which as you can see, dipped pretty low during the December swoon.
Chart mine; data from US Treasury.
I use a 7-day moving average, which is fairly sensitive to these short-term movements like we saw in December and January. So the current prediction is for recession at the very beginning of 2020 at the earliest, and Q3 2021 at the latest. I think weakness in the rest of the world is going to drag us down throughout the year and it will be closer to the early part of that range.
But, Don't Trust Anyone's Prediction of Recession
Including mine. Recessions are notoriously difficult to call at first, and usually, we don't know until a quarter or two after it's already started. For example, in the last go around, then CNBC talking head and current White House Chief Economic Advisor, Larry Kudlow had this to say when we were already in recession in December 2007:
There is no recession. Despite all the doom and gloom from the economic pessimistas, the resilient U.S economy continues moving ahead 'quarter after quarter, year after year' defying dire forecasts and delivering positive growth. In fact, we are about to enter the seventh consecutive year of the Bush boom…
There's no recession coming. The pessimistas were wrong. It's not going to happen. At a bare minimum, we are looking at Goldilocks 2.0. (And that's a minimum). Goldilocks is alive and well. The Bush boom is alive and well. It's finishing up its sixth consecutive year with more to come. Yes, it's still the greatest story never told.
Oof. But this is not to pick on Kudlow, except for his florid prose, because many, many people missed this one too. Expect more of the same this time around.
Fed Policy in the Twitter Age
Pictured: FOMC January presser. Photo Source
So, we are all children who need to be spoon-fed. Or at least this is the conclusion that Jay Powell and the FOMC have come to. "Plain English" is out and FedSpeak is back in. Congratulations.
Saying, "Hey, the economy looks real good, but data is off its peaks and there are some storm-clouds on the horizon that we're keeping a close eye on," was not good enough back in December, because it did not include the FedSpeak keywords, "patient," "data-dependent," or "flexible."
Policy has not changed, just how they are expressing it. With a long shutdown in the rearview and another one looking increasingly likely, and a deteriorating global economy, and without access to the preliminary Q4 GDP data because of said shutdown, were people really thinking the Fed was going to raise rates in the near term? Powell mistakenly thought talking about the data would qualify as "data-dependent," but we all couldn't figure that out in December. Give me my pacifier.
This nonsense is one of the main reasons we should switch to nominal GDP targeting, which would eliminate all this guesswork and insane tea-leaf reading.
The Fed has very little control over long-term rates, which are the important rates that fund investment. Those have been coming down for over a year now, even as the Fed Funds was raised 100 bps. They are certainly not in control of the 1-year spike.
Here are the charts for the Fed Funds and the 10-Year Treasury since November 1990 when they were both around 8.2%:
Does that look like the Fed is in control of that 10-year rate to you?
But more to the point, interest rate hikes when done slowly and deliberately do not tank investment or at least good investment. In fact, extended periods of low interest rates lead to the interest rate trap, where good money goes to marginal investments that inevitably fail in the next recession, creating debt bubbles and deeper losses. Or worse, a liquidity trap.
Or think of it this way: any investment that would be cancelled because of a yearlong rise in the Fed Funds rate from 150 to 250 was probably a really bad idea in the first place.
Eyeballing the Curve
Another way to look at the yield curve is to chart it out and see what conclusions we can draw from eyeballing it. The chart has Tuesday's close in blue, the steepest day in the sample (12/31/13) in green and the flattest day in the sample (12/4/18) in red.
Chart mine; data from US Treasury.
A few things stand out here. Number one is that the 10-year bond has barely budged in 5 years. Look at all the movement on the short end over the last 5 years (green to blue line), but the 10-year is down 24 bps. As we might expect, Fed policy is having much more of an effect on the short end of the curve than the long end where market forces are more in effect. The market says long-term rates should remain low.
Another way to look at the chart is the slopes of the lines you see, which are represented by the x-coefficients in the regression equations in the top-right. Positive is normal, slightly positive is flattening, zero is flat, and negative is inverted. As you can see, we're getting pretty close to zero there, and we are very close to our flattest day in the sample.
The main conclusion here is that the yield curve continues to flatten and that the action in yield curve spreads is happening primarily at the long end, which are the rates least in the Fed's control.
The Fed Model
The New York Fed also has a yield-curve based model for recession. Because they're the Fed, and I'm just me, we should probably have a look, right?
The Fed's model is based on the 3-month to 10-year spread, not the 2-10 as is more commonly used, and they provide some very good evidence of the efficacy of the 3-month to 10-year as a predictor of recession, so I will also begin keeping track of that as we head into the home stretch here.
In any event, this next chart from the Fed takes us through the end of January, and we can see that, while the back-testing is OK, it looks a little slow to react to changes in the spread in some recessions, and we can also see some false-positives in the 1990s.
Source: NY Fed
The 6-month to 10-year has been declining rapidly in the last 3 months, going from 89 bps in early November to 24 bps at the close of the year, at 29 as of the end of January.
At the end of January, the Fed model put the probability of recession in January 2020 at around 24%. Let's zoom in on the last year there, where the probability has spiked considerably.
Chart mine; data source: NY Fed
So, you can see that the recent narrowing of the spread has caused the Fed model to start to spike in November 2019, one year out.
More Spreads: 30-Year Treasury to 30-Year Mortgage
This spread can be seen as the price of the implicit risk of lending to the consumers on the most vanilla type of mortgage. A bank has cash and they want to lend it at a 30-year fixed rate. They can lend it to the US Treasury at almost zero risk. Or they can lend it to a homebuyer and get a higher rate, but more risk of default and early repayment. So, when the spread is low, banks think these risks are low; when the spread is high or rising, banks think these risks are increasing.
After a lot of up and down in the early part of the cycle, around 2015 this noisy data set settled into the 100 bps range. Then, at the end of 2017 through the end of Q2, the spread found a new equilibrium in the 150 bps range. But January was risk-on in the bond market, and we will see this on all of our spreads in this section
In the historical data, the spread rose sharply going into recession, so it will be interesting to see how this progresses as growth slows and we move towards recession, and I will be keeping an eye out for similar movements like H1 2018.
More Spreads: Corporate Debt
The 10- and 30-year Treasury to corporate debt spreads, which, like the mortgage spread, is going to tell us about the implied risk of lending to the AAA-rated corporations with the best credit. In the full data set, the spreads rise sharply into the last 2 recessions, but not 1991, so it's unclear if there's a strong relationship with recession like the 10-2 spread. Again, after a period of declining risk, investors dove back in during January. The 30-year spread:
And the 10-year spread:
Another window into corporate risk is the BBB-AAA bond spread. BBBs are the lowest level of "investment grade" bonds, that often turn out to be not very investable once recession rolls around. So as bond investors fear recession coming, many BBBs get repriced as junk and the effective yield soars. So where we at? Again, January was risk-on.
And the CCC-AAA spread. Even junk made a comeback in January.
Yield Curve Bullets
Too long? Didn't read? Here are some handy bullets:
- The trend in the yield curve continues to be negative.
- The changes in the spread are being driven by the long end, the rates least in the Fed's control.
- The 1-year spike that formed at the end of 2018 indicates investors believe rates will rise and then fall after a year.
- Models based around the yield curve are starting to predict recessions coming sooner rather than later. The earliest seems to be the end of 2019.
- The price of consumer and corporate risk is rising, but January saw a reversal of that.
I will try and update this article monthly with new data.
What you make of all this is up to you. Despite the risk-on mood of January, there are many storm clouds ahead. The Chinese economy is grinding to a halt. The eurozone is slowing and Italy is already in recession. We just came off a long shutdown and another is looking unavoidable. The trade picture still haunts. Forward estimates of 2019 earnings growth keep getting reduced and may be negative before all is said and done. To me, these all point to a recession sooner rather than later. I am a Fat Bear who is happy to sit out rallies like January's when the horizon looks bleak. Your milage may vary.
Thanks for reading. Comments? Questions? Insults? Have at it?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Hedge positioning