Inversion Panic Is A False-Flag

Summary

• 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 »

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 accounts, and/or bank credit is growing, the stock market and the economy will be supported. In other words, as long as money is flowing into the economy, recessions and bear markets won't happen. That is why, although the investment Twitterverse is alive and writhing with monetarist rants about "inversions", we point out that 'inversions' are not a sign from the gods that the world is ending.

The chart below shows various rate differentials, the Fed funds rate, and the SPX over the last 40-years. The 10y-2y differential has the fewest number of false signals; the other differentials invert often and, therefore, cannot be relied on as recession signals. Even the 10y-2y inversion has to be taken with a grain of proverbial salt since recessions can take 6-18 months to develop following an inversion.

ANG Traders and stockcharts.com

Although no two markets are exactly alike, there is a strong similarity between the mid-1990s and today (green highlights). The two following charts show a closer look at those two periods. Notice that in the mid-90s, the 10y-2y inverted in the Spring of 1998 and then again at the start of 2000, but the bear market (orange vertical line) did not start until 8-months later. The other differentials inverted several times, giving false signals.

ANG Traders and stockcharts.com

At present, the 10y-2y has just inverted for the first time (it came close in 2019, but did not invert). Statistically, a recession is unlikely to occur earlier than 6-months from now.

ANG Traders and stockcharts.com

...and when we add unemployment to the picture, we see that, historically, unemployment starts rising before a bear market develops (green arrows below); unemployment continues to move lower which means a recession is not near (chart below).

Differential and unemployment (stockcharts.com and ANG Traders)

It is too early to be fretting about recession, especially when we consider the fund flows that are being injected into the economy.

The net-transfer, from the Treasury to the private-sector, for the month of March was +$197B, and for Q1 (calendar) the net-transfer was +$421B, which is very good, but 55% less than the +$944B that was transferred during Q1 2021. As a result, 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.

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.

Comments

[Mark Chapman]

Thanks for the article. I just wonder how the gig economy is going to skew that unemployment signal, rendering it less useful.

[ANG Traders]

@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]

@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]

@User 47429802 Like you point out, since we are looking at the peak, it makes no difference.

[David de los Ángeles Buendía]

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]

@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]

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.

fred.stlouisfed.org/...

[ANG Traders]

@David de los Ángeles Buendía I see the 10y-3m inverting more than any other differential (bottom panel on the first chart).

[David-McCormick]

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.

[Green Chiles]

@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]

@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.

[Green Chiles]

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]

@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.

[Green Chiles]

@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]

@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]

Good article. Thank you