The Yield Curve Collapse Deepens

Most of the time, longer dated bonds yield more than shorter dated bonds, as compensation for their greater risk. Occasionally this configuration reverses. And investors take note, because it’s one of the most reliable omens of deflationary episodes, including falling stock prices. The last significant inversion occurred in 2019, for example, prefiguring the stock price collapse of the spring of 2020. Though it may be tempting to dismiss that as exceptional due to the outbreak of Covid 19, a better interpretation is that a deflationary squall was on the way anyway. This recalls the stock market decline circa 09-11, which at the time was chalked up to the terrorist attacks, but which is actually quite difficult to pick out on a chart of the stock market, as it appears as just another of a series of drops as the market did its 2 1/2 year impression of a ball bouncing down the stairs.

In fact, yield curve inversions occurred before both of these episodes, as well as several others over the decades that had no extra-economic drama associated therewith, 2008 included.

The current yield curve inversion is unlikely to be any different, especially since it is now the broadest and deepest in four decades.

As of yesterday, the one year yield was 4.76%, versus a ten year at 3.69%, a deep 107 bp inversion.  The inversion is exceptionally broad as well, with the three month at 4.41% versus 3.74% all the way out at thirty years.

The high water market for yield, and the price low, for five year maturities occurred on October 20, with ten, twenty and thirty year yields peaking on October 24.

Lead times vary, but the shape of the shorter end of the curve yields some hints. The exercise is complicated by Fed “forward guidance” efforts because they also shape the shorter end of the curve, but the more imminent signal arises not when short rates rise, but when they start to fall … the market adage “buy the rumor sell the news” is apropos … the Fed cut all the way through the last two major stock bear markets. Regardless, a broad inference that 2023 is shaping up to be decidedly deflationary is far from unjustified.

8 thoughts on “The Yield Curve Collapse Deepens

  1. Bill Terrell says:

    If the initial market reaction is any indication, Powell took a step in the higher inflation direction today. In a Brookings speech and subsequent interview, Powell said virtually nothing new … that the FOMC could downshift to a slower pace of hiking at the expense of a likely higher terminal rate.

    But markets may have expected a more hawkish tone, because this slammed the dollar, which declined versus just about everything else, from foreign currencies to bonds to stocks to commodities. This real time plunge in purchasing power represents an inflationary impulse that will ripple throughout the economy in the coming months and years, in opposition to the disinflationary impulses from earlier this year.

    Wall Street dominated financial media are, however, unsurprisingly focusing on stock prices and spinning this dollar plunge as a market celebration of “positive” economic news.

    If past is any guide, this is the exact opposite of what Powell and Co want to see, and could be met with some pushback in the coming days. But it’s also possible this is a deliberate attempt to soften the collapse in the yield curve … pushing out policy rate hikes favors slightly lower near term rates and slightly higher long term rates than would otherwise be the case.

    The markets are putting all their focus on the slightly easier near term policy and forgetting about the higher terminal rate part. This isn’t surprising; they know that despite the talk, the Fed has virtually no commitment to policy several meetings in the future. The FOMC has so overused and abused “forward guidance” it barely has any effect left.

    This could however paradoxically box the Fed in … because it means hotter inflation data in the months ahead, which would then pressure it to follow through with the higher rates anyway.

  2. jk says:

    kashkari commented “good” when asked about a stock market dip not so long ago. the fed wants stocks down as an indicator of “tighter” financial conditions. every time equities go up they signal to the fed that it should raise rates more. so, yes, at a slower rate if they do 50bps at the december meeting, but as you say the terminal rate will be higher. i think money managers, however, are happy to find any excuse to push up the market into year end – that’s when most bonuses are calculated.

    1. Bill Terrell says:

      I think you nailed it, JK. Kashkari’s metamorphosis from uber dove to uber hawk has been whiplash inducing. No question the Fed has been trying to throw cold water on stock prices. Exhibit A was Powell at Jackson Hole and B during the press conference after the last meeting … when told the market had rallied in response to the FOMC statement he immediately ticked off a list of hawkish talking points. Remarkable enough that the Bloomberg anchor commented on it several times.

      But is that changing? Was the market response to yesterday’s speech and interview what he wanted? I think we’ll only know when we see whether Fed speakers push back on it over the next few days. There’s a pre-meeting quiet period coming up so the window isn’t long.

      I also like your observation about money managers (including corporate execs plying buybacks) trying to push through year end. This also reminds me of 2008, when stock prices topped out in October 2007 but things didn’t really start to unravel until January. We also saw that seasonal pattern at work at the beginning of this year. Of course far from an exact science … we saw almost the opposite at the end of 2018 into 2019.

      At the same time, it still appears to be less about stock values increasing than the dollar value decreasing … the latter explains not only the stock price pop but also bonds, gold, commodities, etc. Over the last two days for instance, long treasuries (EDV) are up 5.1%, silver 7.1% … in dollar terms.

      The correlation – with multiple and variable lags – between asset price inflation and consumer price inflation is unmistakable. The Fed formulation is “financial conditions”, but it boils down to almost the same thing. If I were in Powell’s shoes, I’d angle for 75 bp if the S&P is over 4000 on the decision date. Or maybe ramp up MBS roll off. The financial markets give such accurate real time feedback on how tight monetary policy is or isn’t, making policy should be child’s play.

    2. Bill Terrell says:

      JK – I believe the new 1% excise tax in stock buybacks goes into effect January 1. This isn’t huge, but it might be enough to move a few CFOs to accelerate buybacks that would otherwise be done early in 2023 into year end 2022. In which case some stock price strength late this year could be borrowed from early next year.

  3. jk says:

    given today’s jobs number, unemployment rate still at 3.7% and wages up 5% yoy i think we have a lot more rate hikes in our future. meanwhile the 2s10s is inverted by 76bps.

    by definition the fed will overshoot on the tightening cycle. this follows from the fact that they’ve decided to track lagging indicators. so a recession is in our future, along with further weakening of the dollar imo.

    1. Bill Terrell says:

      Much agreed, JK. The Federal Open Mouth Committee already has egg on its face having guided expectations down to 50 bp this month. Same mistake I’ve complained about for years; too much emphasis on “forward guidance” and not enough on just doing what the data call for when they call for it.

      And your point about lagging indicators too … this comes ironically after it has apparently subordinated real time “financial conditions” to them. It’s focus on lagging indicators leaves it almost perpetually out of sync and often procyclical.

      Personally, with that orgy of excess in 2020-2021, I think the Fed pretty much committed itself to now “overtighten”.

      What would you get if the Fed only overloosened, and never overtightened?

      Powell says he wants to slow down so they don’t have to cut prematurely. That’s wrong. Look at the how markets are taking it … the dollar is getting trashed, financial conditions are easing, undoing much of the progress the Fed has made. What would be so terrible about cutting?

      Why not do 75, and if you think you need to take back 25 bp the next meeting, why not? In all the monetary policy canon, where is it written that short term rates may only move in long unidirectional series?

      That’s not economics, it’s habit. And another major contributor to the Fed always being behind the curve. It thinks it has to commit to a whole series of moves, so it waits for an accumulation of incontrovertible evidence.

  4. Milton Kuo says:

    >What would you get if the Fed only overloosened, and never overtightened?

    An incompetent and corrupt central bank that is a serial bubble blower (resulting in corresponding, devastating crashes) such as what we have had since circa 1994? 😀