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Inversion Panic Is A False-Flag

Apr. 04, 2022 9:32 PM ETSPY, DIA, QQQ, IWM28 Comments


  • History shows that rate inversions happen often, but recessions are rare.
  • The 10y-2y differential, in combination with the unemployment rate, provides the most consistent advanced signal of a recession.
  • Even with the 10y-2y inversion, recessions lag by 6-18 months.
  • This idea was discussed in more depth with members of my private investing community, Away From The Herd. Learn More »

Recession Road Sign

ZargonDesign/E+ via Getty Images

In the following piece, we try to counter the wide-spread obsession with rate inversions as a signal of imminent recession.

As our subscribers know, monetary policy (rate adjustment) is secondary to fiscal policy; as long as the government is net-transferring money to private bank

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This article was written by

ANG Traders profile picture

ANG Traders is an investor with 40+ years of experience and has degrees in math, science, and education. He believes that Modern Monetary Theory analysis provides the best predictions for market action and staying with the primary trend is key to wealth accumulation.

He leads the investing group Away From The Herd, along with David Huston and Alan Longbon. Their working-hypothesis is that, in addition to Federal fund flows, the only other constant in the market is the human emotion of fear, the fear of losing and fear of missing out (greed). These emotions leave repetitive patterns in the pricing history of the market which informs investors about probable futures. ANG Traders and team act on their research with stocks, index ETFs, and options - according to the risk/reward dynamics they find in the market. Features include real-time trade alerts, weekly market analysis, technical analysis, and a chat room. Learn more.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

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Comments (28)

Mark Chapman profile picture
Thanks for the article. I just wonder how the gig economy is going to skew that unemployment signal, rendering it less useful.
ANG Traders profile picture
@Mark Chapman Good question. I will go with history until I see a change. My default position is that "it is not different this time".
User 47429802 profile picture
@ANG Traders

On your last chart, is the SPX linear or log scale? It looks linear to me. Can you graph again with SPX as log? I wonder if it makes much difference, especially since you are looking at the peak? Just curious...
ANG Traders profile picture
@User 47429802 Like you point out, since we are looking at the peak, it makes no difference.
David de los Ángeles Buendía profile picture
Hello @ANG Traders ,

There is no "The Yield Curve". There are many yield curves. They are not all created equal.

Most economists, including the Federal Reserve Bank of Cleveland (FRBC), use the 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity (T10Y3M) curve [1]. The FRBC has an entire research arm dedicated to the assessment of the T10Y3M [2]. This yield curve is stable. It has not inverted. The T10Y3M has historically peaked between 350 and 400 basis points (bp) usually two or three years after the inversion. It is just now only two years after the first inversion and the spread is only 185 bp[2]. This might suggest that yield curve has not yet peaked and a recession is not yet within the foreseeable future.

Credit and interest rates follow the Business Cycle. Generally longer term forms of credit pay more on interest then do shorter term forms. The spread between the interest on short term credit is high early in the Business Cycle as there is more demand for long-term credit early in the cycle and less demand later in the cycle. Demand for short term credit is more stable and does change as much.

More importantly, the market for long-term credit is very elastic while the market for short-term credit is very inelastic. As a result small changes in demand for short-term credit causes large changes in the price, i.e. the interest rate while the price of long term credit is much more stable. It is this difference in elasticity and volatility that accounts for the fact that the difference between interest rates for short term credit and long term credit peak just before a recovery and bottom-out just before a recession.

In some types of credit, this spread in yields over the term of the credit, that is to say, the Yield Curve, can even invert with short term forms of credit yielding higher interest than shorter term forms. The Yield Curve for some UST securities invert just before a recession but all yield curves are at a minimum before a recession.

The T10Y2Y inverts much more frequently than does the the 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity (T10Y3M) curve and in not nearly as a predictive a fashion [3].

[1] fred.stlouisfed.org/...
[2] www.clevelandfed.org/...

[3] fred.stlouisfed.org/...
ANG Traders profile picture
@David de los Ángeles Buendía
The first chart in the article shows the most common differentials, including the 10y-3M. The 10y-2y is the one with the least false-signals. If you add unemployment (last chart in the article) to the 10y-2y inversion, then you have the best signal for a recession. IMHO
David de los Ángeles Buendía profile picture
Hello @ANG Traders ,

Yes, I am agreeing with you that there is not signal of a proximate recession. The 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity (T10Y2Y) has more false positive signals, not fewer. I would not disagree that combing the T10Y2Y with the unemployment rate is probably a useful tool, but why do that when the the 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity (T10Y3M) gives a rather reliable tool all by itself.

ANG Traders profile picture
@David de los Ángeles Buendía I see the 10y-3m inverting more than any other differential (bottom panel on the first chart).
David-McCormick profile picture
I think the author makes a very fair statement when he says: "we can't expect the same kind of growth as last year at this time-new highs in the stock market will not be as frequent as last year-but a recession is not something we should be worried about, regardless of any rate-inversions." While I am fairly sure we are headed for economic recession is that bad? There is a cleansing effect of recession which roots out a lot of weak entities in the economy. One of the problems of socialist systems is that they retain a lot of "walking dead" (government supported) economic entities rather than ridding society of bad ideas. Recession creates buying opportunities. In my 55 years of trading stocks in accounts in my own name, I have seldom found the firts inversion of interest rates to signal the end of the bull market. It is a signal, but we may have months perhaps a year before the bear market ensues with vigour. Thanks for a timely article.
@David-McCormick just because recessions are a feature of capitalism does logically imply that they are necessary to it. I can evaluate the prospects of a company and their business without an economy wide recession. A poorly managed company can (and frequently do) go out of business without a recession. And Australia went some 29 years without a recession, until covid--and does not appear to suffer from "malinvestment". Whereas Mexico has a recession every 5 years or so--and does not seem to me to be any "cleaner" for it.
David-McCormick profile picture
@Green Chiles Australia has had the good fortune to be SELLING the raw materials that the Chinese Reds were buying in vast quantities for "29 years." Right ? I do not fault the Australians for their good fortune. While Australia helped supply the coal, iron ore and other raw materials to Chinese manufacturers -- those Chinese firms were able to run a lot of firms with higher cost structure in OTHER NATIONS out of business. That is the normal cleansing or "creative destruction" of the economists like Joseph Schumpeter and the Chicago school folk advocate. Both happily and perhaps sadly for the Australians, they have become a bit dependent on raw material exports. I continue to look at the upside of the coming recession in the USA as a possible buying opportunity for selected stocks -- as well as the possible departure of high cost, non-competitive technologies.
Yes, but technically speaking we won't know a recession is underway until 6 months after it has started. So something that gives 6-18 months warning (let's call it 12 months typically) seems pretty useful for those of us who don't need to sell at the top.
ANG Traders profile picture
@Green Chiles
The 6-18 month lag is for the best of the inversions (10-2). If the unemployment is rising, THEN it makes sense to pay attention. Otherwise, I don't see any benefit to cutting loose when it inverts. And since the other inversions happen frequently without any connection to recessions, it makes little sense to be selling on that false signal.
@ANG Traders Ok, in that case we just look at the 10-2, which has been a very good (nearly perfect) indicator over the past 30 years. If I think prices will be lower in 12 months why buy (or hold) now? Employment is a trailing indicator. Too late. Shouldn't we want a lag, to give us time to act?
ANG Traders profile picture
@Green Chiles look closely at the last chart. The unemployment goes up before the bear market. Waiting for the 10-2 and the unemployment gives you the best results. Hard to make money in the market if you spend 12-months of a bull market sitting in the dressing room. By adding unemployment you reduce it to 2-6 months.
peterspore profile picture
Good article. Thank you
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