Don’t fight the yield curve inversion

It’s always the same. Whenever we’re late cycle and the yield curve inverts indicating a looming recession, bulls come out of the woodwork to describe why this time is different.  Albert Edwards takes them to task:

Does the inversion of the US 10y-2y yield curveindicate a recessionis on its way? This is the question everyone is asking right now–even before the Fed tightening cycle has got beyond one paltry rate hike. Fed tightening cycles usually end in recession as they continue along this path until something breaks in the economy or markets.

But it’s not the Fed’s fault…apparently, it’s ours!

 I’m going to take a sober look at the inversionof the 10y-2y part of the yield curve we saw on Wednesday. Inversion almost always precedes recession–there have only been two false signals in 65 years. That is a great record, especially when compared to economists’ forecasts.

At this stage in the economic cycle, I get a profound sense of déjà vu. Once inversion occurs a whole new industry emerges, devoted to dismissing the relevance of the signal. Even the Fed has joined in, on 25 March publishing a paper entitled (Don’t Fear) The Yield Curve, Reprise. In response I wrote on Twitter“ Possibly the most robust indicator of an impending recession is when the Fed dismisses the inverting yield curve as a predictor of impending recession.”

 I am stunned by that paper. I’ve read some utter nonsense from the central banks before, but this surely tops them all. In what must surely be the worst ever example offinancial gaslighting and blame shifting, the Federal Reserve wrote that it’s our fault that a 10y-2yinversion precedes recession because we in the markets get too pessimistic about it!

 To quote:“…ultimately, we argue there is no need to fear the 2-10 spread, or any other spread measure for that matter. At best, the predictive power of term spreads is a case of ‘reverse causality. ’That is, term spreads predict recessions because they impound pessimistic—often accurately pessimistic—expectations that market participants have already formed about the economy, and thus an expected cessation in monetary policy tightening. Thus, term spreads could have little or no economic impact in and of themselves. Nevertheless, as FDR might have pointed out, it can only make things worse if investors not only fear the prospect of a recession, but at the same time, are spooked by that fear itself, which is mirrored in inverted term spreads.”

That is, in my humble opinion, utter unadulterated bilge. Nevertheless, the Fed should take note of the chart below, in which the dotted line shows how consumers feel about their prospects compared to their current situation. Unpolluted by questions about the impact of QE in depressing the shape of the yield curve, this sure looks to be confirming a recession to me.

And me. Deutsche agrees and notes one reason why the Fed will overdo it:

The Fed prefers the 18m3m–3m yield curve as a portent of recessions, as they feel it offers a clearer read of near-term monetary policy expectations not clouded by longer-term influences that beleaguer the signal of 10y yields …

The spread between 18m forward 3m yield and 3m yield plus the 2s10s yield curve is the biggest gap on record…

There is a meaningful difference in the recession probabilities from our economists implied by 18m3m–3 m and 2s10s yield curves. Which one is right …?

I think the Fed’s argument ignores the huge impact of animal spirits. Rational economic agents should gravitate to safer short-term assets under inverted curves regardless of why it occurs. While not cast iron proof, bank NIMs tend to be correlated to steepness of YC.

Sometimes you just have to look out the window for confirmation:

  • European energy and war shocks.
  • China property and OMICRON shocks.
  • US Fed superhawk shock sucking trade away from the first two.
  • Post-COVID supplyside unwinds.

The 2-10 inversion looks entirely logical and consistent with broader data and developments to me and if the Fed doesn’t see it then I am even more convinced a global recession is coming.

Moreover, it is coming much faster than it would normally with an accelerated cycle going bust.

Houses and Holes

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