The yield curve is often portrayed as one of the most reliable indicators of the economy’s future direction. Why is this the case? More importantly, what can and can’t it tell us?
The mainstream media has been focused on whether or not the US yield curve indicates a looming recession, which implies that what they want to know is whether or not a recession will occur.
To them, it is a binary outcome: recession = bad for markets, and no recession = good for markets.
Unfortunately reality isn’t so simple.
Because what really matters isn’t whether or not a recession occurs, or the probability of one occurring.
It’s the depth of the recession that counts.
One way to appreciate this is to ask yourself, would you rather have a high probability of a shallow recession that’s over in a few months?
Or a low probability of a deep recession that lasts for more than a year, and has the potential to develop into a full blown economic depression?
Another perspective from which to think about this is through the concept of expected value. Mathematically, The expected value associated with probabilistic outcomes is the sum of the product of its probabilities and their payoffs.
The negative payoff that results from low probability, deep recessions, is so large that it drives the expected value below 0. This happens even though the probability of the opposite happening, i..e no recession, is much higher.
This isn’t to say that the probability of a recession doesn’t matter at all. It does, simply because the vast majority of folks would rather there not be a recession at all.
With this in mind, it is important to remember that the yield curve, in this case defined as the spread between 2y and 10y US Treasury (UST) yields, has been accurately predicting recessions since the 1970s.
Such a record deserves respect, which is why we have been tracking the flattening and inversion in the 2s10s for months in the Macro Edge.
While some mainstream commentators point out that this time could be the exception, and it could be, they are missing two broader points.
The first being, even if it turns out that this time truly is the exception, we have no way of knowing it right now.
All we have are probabilities based on what can be observed from the past, which begs the question, would you want to bet against a track record as solid as the 2s10s?
The second point is what’s stated above, that the depth of recession matters more than the probability of its occurrence.
Here, unfortunately, the yield curve does little to help us as it doesn’t indicate how serious a future recession could be.
Why is that?
To be continued…
Before we can answer why the yield curve doesn’t indicate how serious a future recession could be, we need to first understand what the shape of the curve represents.
In normal, non-recessionary times, a yield curve should be sloping upwards. This is simply due to the fact that short term interest rates are normally lower than long term ones.
This comes down to two main factors, namely uncertainty and inflation.
The first is easy to understand, as the longer the time frame, the greater the potential for adverse and unexpected events to occur. Think of it this way, in general, it is more probable that a financial crisis will occur in the next 10 years than it is in the next week.
Simply put, more time on a loan means more time for things to go wrong.
The second factor, inflation, is a bit more difficult to understand, as inflation (or deflation) is an ever present phenomena. That is, inflation is a component of yields at every point in the yield curve.
In other words, inflation is a factor which investors have to consider when purchasing or selling USTs. They expect to be compensated for their expectations of future inflation, and the actions they take come to reflect these expectations in UST yields.
Now, the degree to which inflation matters in yields differs along different points in the curve.
The short end of the curve, typically thought of as yields ranging from the 1 month to 2 year tenors, aren’t as sensitive to inflation expectations as the middle (belly), and long end of the curve.
While it is tempting to immediately jump to the conclusion that an inversion between the 2s and 10s means the market is pricing in higher inflation in 2y yields than the 10s, this would be too reductive.
This is simply due to inflation generally* remaining stable over shorter time frames, but not longer ones.
Inflation tends to only change by small amounts from month to month under normal* circumstances. If traders or investors were looking to purchase a 1 month T Bill, inflation would not be one of their main concerns (if at all).
On the other hand, inflation can and does change by large amounts over years.
This makes longer term UST yields more sensitive to investors’ expectations for inflation. The longer the tenor of the bond, the more sensitive it will be to inflation. Since economies are largely expected to grow over the long term, inflation is also expected to be higher.
Consequently, how the two factors, uncertainty and inflation, change over time helps to give the yield curve its shape.
Short term yields are normally lower than long term ones because uncertainty and inflation tend to be lower in the near future. As uncertainty and inflation increase the further out into the future we go, yields increase in kind.
The result of which is, in normal times, short term yields being lower than long term ones, creating an upward sloping yield curve.
But what about when times are not “normal”?
*Exceptions to “generally” and “normal” would include periods of severe economic shocks, or in the extreme, hyperinflation
To be continued…
When times aren’t “normal” (like now), the shape of the yield curve changes, which is why it is so closely watched by market participants.
How and why does it change?
The first major change a yield curve undergoes when economic conditions start to sour is what is known as flattening.
This is most easily observed graphically.
Flattening occurs when short term yields rise more relative to long term ones, or, long term yields fall more than short term ones.
The converse is true when economic conditions start to improve in the aftermath of a recession. In this case, the yield curve is said to steepen.
Steepening occurs when short term yields fall by more than long term yields, or, when long term yields rise by more than short term ones.
The difference between short and long term yields, known as a “spread”, measures the degree of flattening or steepening.
Spreads can be calculated between any two points of the yield curve. One of the most commonly followed spreads is the one between US 2y and US 10y yields, or the 2s10s.
The 2y in this spread represents the short end of the curve, and the 10y the long end, which makes the 2s10s a good indicator of the market’s expectations for future growth.
Should the 2s10s decrease, it means that the yield curve is flattening. This implies that the market is expecting lower inflation from economic growth in the long term (10 years) relative to the short (2 years).
The more drastic the flattening, that is the closer to 0 a spread gets, the higher the potential for a recession in the near future.
When a spread falls below 0, the yield curve is said to be inverted between those points, as it was in early April.
Why does the yield curve change in such ways?
To be continued…
Let’s look at this from the simplest of perspectives.
Ignore, for the moment, that the yield curve we’ve been referring to is that of UST yields. Instead, just think of yields as interest rates in the most basic sense – how much a business would pay to borrow money.
The Business Perspective
In normal times, a business has no trouble accessing credit from banks, and would be able to take out short term loans at a lower interest rate than it pays on long term loans.
However, when economic conditions deteriorate, the same business will find it increasingly difficult to borrow from its banks. This is due to banks becoming more risk averse, and charging higher interest rates to compensate for the higher level of risk.
More importantly, as conditions sour, more and more companies will find themselves unable to generate the same amount of revenues as before. As more struggle to generate the amount of sales needed to cover their costs, more start to borrow money from banks to meet their liabilities.
This increase in demand for loans also drives interest rates higher, to the point where it becomes more expensive to borrow money in the short term than the long.
If we were to interpret this using the perspective of uncertainty over a loan getting repaid, it means that banks think that businesses are more likely to default in the near future than over the long term.
In other words, a crisis is imminent.
Put another way, demand for money is higher during times of economic stress, even as banks’ risk aversion increases.
The result? Tighter liquidity conditions and increased difficulty in obtaining debt financing as rates increase and creditors impose more stringent requirements.
Note that interest rates don’t always move in the same direction as we expect them to.
A good example would be when USTs sold off for a period of time at the height of 2020’s panic. This ran contrary to conventional thinking, which believes that “risk off” periods entail falling yields.
In other words, in times of crisis and uncertainty, yields should be falling as everyone rushes to buy USTs. Yet in that period of time, UST yields rose in the middle of a panic the scale of which the world had not seen since 2008.
Suffice to say that it is important for you not to hold on to fixed and preconceived notions of what rates will do at any one point in time.
The Repo/Collateral Perspective
Now let us put this in context of the UST yield curve, with an important extra bit of information added in. Which is that USTs are themselves money. Not money in the conventional understanding, but money as collateral for trillions in transactions undertaken in the global repo market.
Hence, the example given above, of businesses and loans, translates directly to the yield curve. In place of businesses, we have financial institutions (banks, hedge funds, pension funds, asset managers etc), and instead of bank loans we have collateral.
Consequently, the shape of the US yield curve directly reflects the supply and demand for USTs as collateral, which are the lifeblood of the global repo market.
Returning to our simple example of businesses and loans, the first, “normal times” scenario describes a regularly shaped US yield curve.
The higher inflation is expected to be in the long term, whether due to economic growth or shocks, the higher longer term interest rates will be. This in turn causes the yield curve to steepen, as rates at the long end rise faster than those at the front (short end).
In the wider economy, money is easily available (remember, money supply is loan creation, not bank reserves as loans are easier to come by.
In the repo market, collateral is widely available as confidence flows through the financial system, and concerns over counterparty defaults aren’t high on the list of concerns.
When the economy turns and conditions deteriorate (the second scenario in the business/loans example), expectations for growth and inflation fall. Uncertainty also rises as banks and repo market participants start to grow more wary of the risk of their trading partners defaulting on their borrowings.
As a result, an increasing number of traders and investors prefer to hold on to their USTs in order to ensure they have enough for their own use should a crisis unfold.
Put another way, folks start to hoard collateral. (The same way banks hoard loans when they are risk averse by lending less and with more stringent requirements)
The natural consequence of this behavior is higher UST prices (lower yields) as market demand for collateral increases while people who own them grow more and more reluctant to sell.
It is important to note that this hoarding occurs at all points of the yield curve, but most noticeably at the short end. This is due to T Bills being the most pristine, and thus most desirable form of collateral.
However, while long end yields experience less of a collateral hoarding effect, they are much harder hit by the repricing of inflation. As growth prospects diminish along with long term inflation expectations, many investors will seek to “lock in” yields while they are still high.
They do so by purchasing longer dated USTs, driving their yields lower. If they come down faster than short end rates, the yield curve flattens.
To be continued…
Now that we know what the shape of the yield curve represents and why it does so, we can finally answer the question asked in Part 1.
Why can’t it tell us the depth of a recession?
The first, and most obvious reason is simply that conditions can change. Quick action taken by the authorities can, at the early stages of a downturn, change the course and depth of a recession.
Unfortunately for us though, the authorities don’t actually know what steps to take.
This is due to the current macroeconomic playbook on economic intervention being conceived entirely from a central-bank-centric perspective. In this worldview, central banks are omnipotent and sit at the center of the financial universe.
However, this is based on a false paradigm, and simply isn’t true.
Banks sit in the middle of the financial system, and are the ones who actually create money, not central banks.
All central banks (in their current form) can do, and all they have been doing over the past 14 years of crisis management, is print bank reserves. But bank reserves are not money that flows into the economy, simply because they aren’t lent out.
The earlier real money, that is not bank reserves, gets pushed into the economy, the lower the probability of a deep and prolonged recession.
In terms of governmental intervention, this real money can take two forms.
The first is fiscal stimulus enacted through legislation, like those passed in 2008, 2009, and 2020, which pumped trillions into the US economy.
Fiscal stimulus is real money due to the fact that cash is transferred directly into citizens’ bank accounts. The government does so by taking the funds from somewhere else, either from the country’s savings (fiscal or other kinds of governmental cash reserves), or by borrowing.
However, fiscal stimulus won’t be very effective in times of great uncertainty, simply because folks must be willing to spend their stimulus money instead of saving (hoarding) them.
After all, would folks spend their stimulus check if they’re out of a job, or uncertain that they will keep their current ones? It is more likely that they would save the money to spend on bills and essentials rather than splurge on big ticket items.
Moreover, checks from the government aren’t a sustainable solution, as folks can’t go to a bank and get loans with them. In order to do so, they need an income, which means jobs, which means bank lending to support the creation and operation of businesses.
To be continued…
Get a different perspective on all things trading & investing every week!