“Because I was inverted.” – Tom Cruise as Pete “Maverick” Mitchell in Top Gun
So, the yield curve is inverted.
What does that mean?
Well, going back to the 1950s, it has a perfect track record of predicting recessions (except for one time in the 1960s), technically two consecutive quarters of negative growth.
The yield on the U.S. Two-Year Treasury Note (some use the U.S. Three-Month Treasury Bill) has been above the yield on the U.S. 10-year Treasury Note for about nine months.
The short end of the curve, the two-year, is tracking short-term interest rates, and the longer-end, the 10-year, is generally reflecting expectations for economic growth.
The mainstream financial media caught up to the story this week because the yield curve inverted the most since the recession of 1981.
(Post Friday’s U.S. employment report and the collapse of Silicon Valley Bank, the two-year yield is currently above the 10-year yield by 90 basis points after having been inverted by more than 105 basis points earlier in the week).
Keep reading for more on the inverted yield curve and why it matters to your portfolio…
Either you lived through that economic contraction in 1981, the second in two years, or at least have some passing knowledge of the downturn, which lasted 16 months and, at that point, was the worst contraction in the U.S. since the Great Depression.
The 1981-82 recession was largely driven by rampant inflation of as much as 14 per cent and the high interest rates of nearly 20 per cent then U.S. Federal Reserve Board Chairman Paul Volcker utilized to slay high prices.
That strategy eventually led to decades of much lower inflation and interest rates and general economic and stock market prosperity.
It is often said that current Fed Chairman Jay Powell would like to walk in Volcker’s inflation-conquering path while avoiding the mistakes of Arthur Burns, the Fed Chairman for most of the 1970s, who stopped raising interest rates thinking that inflation had been tamed only to see it reaccelerate.
Yield Curve as of March 9, 2023
Interestingly, the yield curve would not be nearly as inverted if the Fed was more realistic in its forecast for the path of interest rates – the so-called dot plot – made up of the various Governors predictions where rates will be in the next few years.
That is the opinion of Cameron Crise, a Macro Strategist at Bloomberg, who argues below that if the Fed altered its stance and forecast a higher trajectory for rates to more accurately reflect current conditions instead of maintaining its lower rate estimate regime that has existed since the financial crisis in 2008, or the central bank eliminated the dot plot entirely, then market participants would likely change their expectations for rates and position for the yield curve to steepen:
Fed guidance— specifically the dot plot — might explain virtually all of the 2s-10s inversion.
Not only is the market perception of the long-term neutral rate a lot lower than it used to be, but confidence over that estimate is substantially higher thanks to Fed discussion of the topic and the explicit guidance provided by the long-run projection in the dot plot.
In the absence of the dot plot, the curve would be a lot less inverted (-45 bps).
In other words, 30% to nearly 50% of the curve slope implied by the dot plot feeds through into the market setting of 2s-10s.
At the moment, that’s largely a function of the dot-plot insistence — and the public discussion around it — that the long-run level of the funds rate hasn’t moved.
If the street thought that the long-run average of the funds rate would be 3.5% or more, there is no way that back-end yields would be this low … or that the curve would be this inverted.
It all suggests that an easy way for the Fed to steepen the curve would be to raise the estimate of the long-run neutral rate in a way that would influence the public perception of just how restrictive policy currently is.
Given the individual nature of dot-plot contributions, that might be easier said than done.
But if the Fed — or anyone else — doesn’t like the slope of the curve, look no further than forward guidance.
In the absence of anchoring the market perception, chances are the curve would be quite a bit steeper.
Now, for further discussion and better understanding of the ramifications of an inverted yield curve and what it may mean for your portfolio, we turn to excerpts of a recent Financial Post article by Davis Rosenberg, President and Founder, Rosenberg Research, bearing in mind that Rosenberg is often more bearish than most:
Now let’s delve into the yield curve.
The bellwether 2s/10s curve is now going into its ninth month of inversion.
The average for all the prior cycles over the past five decades is nine months and the median is eight months.
We are destined to surpass these.
The peak inversion, on average, is -75 basis points and we are now at -90 basis points.
We are essentially at or near peak inversion in both duration and magnitude.
And the question is: what comes next?
In the year after the peak inversion, here is what has typically happened.
The recession becomes a lock and that takes the yield on the 10-year T-note down 75 basis points.
The two-year yield plunges closer to 200 basis points, because guess what?
Six months past the peak inversion, the Fed is swinging from tightening to easing.
That is the nature of the interest rate and economic cycle.
As for the S&P 500, from the time of the peak inversion of the curve to the market lows, the index is down an average 23 per cent (median of -17 per cent).
Only when we are 70 per cent of the way into the recession and Fed easing cycle, and only when the central bank has pivoted enough to push the coupon curve into a positive slope, is it safe to start shifting the asset mix into an overweight position in favour of equities.
That could be a year away, and it means that all equity market rallies, as we saw so many times in 2022 and in January of this year, are bear market rallies to be rented, not owned.