Is The Yield Curve Obsolete?

Remarks like “the yield curve is inverted” occur regularly in financial and economic analysis, but aren’t really meaningful by themselves. The Treasury yield curve is a line that shows the yields of Treasury securities by maturity. In order to make a binary statement about it, you have to pick two points on the line to compare. There are no hard and fast rules, but the two and ten year maturities are popular choices. The three month and ten year maturities are another pair. Unless otherwise specified, Financology refers to the one and ten year maturities. But they’re all binary reductions of a far more data rich picture best conveyed graphically. The below is such a picture of the US Treasury yield curve, from 0-30 years, as of the end of last week, 2024 0505.

YieldCurve20240505

Most of the action is in the left side of the chart. There you can clearly see the downslope or inversion of the curve out to about five years. From there, it slopes gradually upward, then downward again from about twenty years on out. This illustrates my opening remark about simplistic binary statements about the inverted or non inverted status of “the yield curve”. This one is inverted, noninverted, and inverted again all at once.

Let’s look at the 1-10 year maturity pair. This pair last inverted on July 16, 2022, and has been continuously inverted for the 96 weeks since. Approaching two years, it is an extraordinarily long stretch.

What’s the significance? Depending on the source, an inverted curve has a perfect or nearly perfect record of forecasting “recessions” over the past several decades. But what’s a “recession”? One traditional definition is two consecutive quarters of negative economic growth. The modern usage is whenever the National Bureau of Economic Research Business Cycle Dating Committee says there has been one.

I’m sorry, but this is not worthy of anything with a pretense to science. If a scientist told you the law of gravity was valid whenever a committee declared it to be, you would rightfully doubt his qualifications, if not his sanity.

So we won’t worry about that. Alas, even the two quarters definition leaves a lot to be desired. It refers to “real” economic growth, which depends on nominal growth less a highly subjective and contrived measure of “inflation”. Not to mention the problems of measuring even nominal growth.

Or even more to the point, the context of the analysis. Are you trying to size up the stock market outlook? If so, your definition of “recession” has little to do with vaguely defined economic constructs and a lot to do with objectively and quantitatively definable hard numbers. If during the period in question, you were better off being invested in cash than stocks, that’s the kind of “recession” you care about.

We could add dimension to the question by adding bonds or gold to the menu, but for our purposes here that’s an issue for another day. For now let’s focus on whether the yield curve as a forecaster of much of anything is still relevant.

Some claim it is not. The curve has been inverted for nearly two years and not much of anything has happened … at least the NBER hasn’t declared a recession as of yet.

But wait … by our investors’ working definition, we’ve already been there done that. Certainly for most of 2022 stocks underperformed cash. Millions of investors experienced a recession, and Wall Street certainly did. If there was any deficiency in the yield curve as a predictor, the recession was well under way before the curve even inverted.

Another frequently glossed over issue is when you start the clock ticking on your recession indicator. When the yield curve first inverts? That can be a long wait … anywhere from 6-24 months has been observed, and we haven’t even reached the 24 month mark yet. It’s still too early to declare the yield curve obsolete on this basis.

What about when it uninverts? This has often been the more timely indicator. It may be overlooked because Wall Street dominated media don’t want to scare the despised “retail” investor out of the market when the “wholesale”(?) folk most want to get out. When it uninverts, the big bad yield curve is out of the way and we can all breathe a sigh of relief and load up on stocks.

Or as is more often the case, forget about it altogether. The yield curve makes the news when it inverts, and is then not mentioned much at all.

This was the case in 2019. The yield curve had flirted with inversion in March, solidly inverted in August, and attracted a lot of attention for it. Then it uninverted in October with hardly any notice. By the time the recession arrived in February of 2020, you could search the financial media high and low without finding any reference to it ever having been inverted.

The takeaway here is that the yield curve’s sterling forecasting record is still unbroken. If this time is different, we won’t know until at least six and maybe twelve months until after the curve has uninverted. And that’s not even counting the aforementioned 2022 recession.

Does that mean that this time couldn’t be different? Not at all. There are some unprecedented forces at work, not least the massive scale of the 2020-2021 monetary explosion, the ongoing massive fiscal deficits, and the equally massive redistribution of Treasury issuance to under one year. To assert that all other precedents remain undisturbed would be naive.

Yet there’s another potential implication that it would be folly to ignore. After such epic monetary and fiscal interventions, and after such a long and deep inversion of the yield curve, that there could be a proportionately massive recession building. When the sea retreats far into the distance and lingers, do you take it as the all clear to revel on the beach?
Or head for the hills?

 

17 thoughts on “Is The Yield Curve Obsolete?

  1. Finster says:

    Let’s reflect on some investment implications.

    Summing up, a case can be made that the state of the financial system is so unprecedented that relying on yield curve precedents is questionable. Yet I’m taking a show me attitude and adopting a working hypothesis that until the yield curve uninverts and remains so for 6-12 months, the balance of risks lies in prematurely dismissing it. If it turns out to be a false alarm, we have our otherwise normal financial due diligence to follow. If it doesn’t, we need to be prepared for a larger-than-life helping of yield curve inversion denouement.

    I’ve already argued that bonds can’t be relied upon to serve their risk-moderating role of the past four decades. The great secular bull market in Treasuries is over, according to both the most casual glance at a long term chart and the dismal fundamental outlook. Of all the uncertainties in finance, this is among the least uncertain.

    The new “Treasury” allocation is a mix of Treasuries and gold. For ETF investors, this is 59/900 SHV, 841/900 GOVT, and part IAU (or your preferred gold fund). Half Treasuries and half gold is a reasonable starting point. Substitute up to a quarter of the gold with silver, platinum & copper. Substitute part of the stocks allocation with a broad commodities fund like COMT (or your preferred commodities fund). And be prepared to revise it as developments warrant.

    The rationale is that the kind of recession risk we’re faced with is one in which stocks and bonds are both vulnerable in real terms even if they appear to perform well in nominal terms. Steep nominal declines at some point in the early going wouldn’t be the least bit surprising … they would be, especially for stocks, an expected development once the curve uninverts. The policy response though could come quickly and transmute bond market declines into currency declines.

    By no means assume that Fed rate cuts would sound the all-clear on stocks. The Fed cut rates all through the last major bear market in stocks (2007-2009) and most of the way through the one before (2000-2002). But as I’ve insisted for years, it’s not the Fed we want to watch, it’s the Treasury yield curve. In particular, be alert for declines in the 1 year Treasury yield. That’s one of the chief danger signals I will be watching for.

    The currency declines are the rationale for the commodity substitutions. The elementary commodities listed (copper, gold, silver & platinum) all have a history of use as money and are partial surrogates for cash when cash itself is at risk. Gold gets the greatest weighting because it is least correlated to stocks. But monetary commodities wouldn’t be the sole beneficiaries; industrial commodities, being more highly correlated, are partial surrogates for stocks.

    The silver lining to this insurance policy is that it wouldn’t be a bad way to be positioned even if the worst of the yield curve implications don’t come to fruition. Inflation will be a fact of life for years and gold and other commodities are generally solid hedges. While stocks are vulnerable to the yield curve omen, especially at the rich valuations of US stocks, they are good long term inflation hedges too, just not necessarily at the same points as gold.

    There will be transient weaknesses. As I’ve discussed before, gold actually tends to weaken when (lagging) official inflation stats are flashing red, because it increases the policy response urgency. Ironically, cash (& TBills) are solid trades for when inflation is making headlines.

    With the foregoing adaptations, the classic 60:40 portfolio (and its individualized customizations) can remain relevant.

  2. Finster says:

    Short term outlook.

    Despite my long term negative view, I recently referred to Treasuries as set up for a “decent trade”. It’s time to take profits on that trade. They’ve moved from the bottom of the trend channel cited to the top.

    I also called for caution with gold as it approached the $2400 level. As expected it’s pulled back. It may be coiling for another spring higher. At least in this instance even if that run doesn’t materialize, it’s a top flight long term holding. Similar remarks apply to my bullish emerging markets call.

    The near term risk to all asset classes except for dollars comes with next week’s CPI release. I called a resurgence in consumer price inflation on the day of the December FOMC meeting and have been right as rain. The Fed has been forced to walk back its reckless rate cut talk and whispers of possible rate hikes have even emerged. Commodity prices turned higher that very day, and the behavior of stock and commodity prices since continues to send the same message. Consumer price inflation continues to reaccelerate.

    Due to the vagaries of the sausage making process that goes into the CPI, however, not to mention the expectations game Wall Street plays, it’s unrealistic to expect that any single month’s release will accurately represent this trend. If next week’s release comes in higher than expected, it will be bullish for cash at the expense of everything else, as it will nudge rates upward. Conversely, a lower than expected release will be bearish for cash and bullish for everything else as it will nudge rates lower.

    But either way, there remains a big slug of inflation still working its way from asset prices to consumer prices. Only a meaningful and non-transitory setback in asset prices will bring meaningful relief on the consumer price inflation front.

  3. jk says:

    for people who wish to hold gold in a taxable account, i would recommend phys instead of iau. the latter is an etf and subject to taxes as a collectible. the former is a closed end fund and eligible for capital gains treatment.

    1. Finster says:

      Thanks JK … I was hoping you’d remind us of that alternative.

      Just so they’re aware of the options and tradeoffs, IAU tracks gold much more closely because of the ETF arbitrage mechanism, but isn’t eligible for the full long term cap gains tax treatment, being taxed as a “collectible”. PHYS is subject to much greater deviations from gold, but that should be less of an issue for a long term holding.

      Another alternative is a mining shares ETF like GDX or RING. But mining shares are not kinds of gold, they’re kinds of stocks, so from an asset class point of view, they’re best treated as part of a stock allocation .

  4. jk says:

    it’s been interesting to note the lack of performance in gold mining stocks compared to the metal itself, only recently beginning to correct.
    .
    https://stockcharts.com/freecharts/perf.php?$gold,gdx,gdxj
    .
    this, i assume, is a function of the demand for gold coming from asia and especially from central banks. central banks buy gold; they do not buy miners. as the price of the metal rises, however, the increase drops straight to the bottom line of the miners [until they start using it to dig more holes, buy the ceo a private jet, etc].
    .
    i expect the miners to outperform gold for a while [years?], but with significantly more volatility. fwiw, i have a bit over 70% of my precious metals allocation in phys [which tracks the gold price fairly closely – the current discount of 1.37% is pretty typical]. a bit less than 30% is in a basket of mostly gold miners, some silver miners, a bit in platinum/palladium mines.

    1. Finster says:

      Precious metals mining stock enthusiasts have been complaining about their failure to keep up with gold for a long time. I’ve been sort of a purist when it comes to gold, using it exclusively as an elementary commodity with a low stock correlation, and so have only owned the mining stocks at their low incidental weights in broader stock ETFs with just bullion ETFs in my IRAs. I have sort of a no-sell rule in my regular taxable account (strictly income) so nothing gets in there if it doesn’t pay a dividend.

      But back in late February I added positions in RING and SLVP to the latter. They looked cheap, had decent dividend yields, had been growing those dividends at a healthy clip, and helped round out my energy and ag stock positions. I wasn’t trying to be clever with timing, but got lucky and caught them just ahead of a 30%-40% rally.

      They look more fully valued now. I would probably still buy them at these prices given the longer term tailwinds of likely increasing metals prices, but don’t expect much more exceptional outperformance on the horizon.

      What do you like for platinum mining? I had IMPUY for a few months last year and it did nothing but go down on apparent infrastructure and power problems in Africa. Having no clue how long that would go on and paying ADR fees, I gave up on it. It does have a nice yield though, so maybe that was just being dumb.

  5. jk says:

    i had a little impuy for a bit and i think i made a little money on it. i’ve sold it and put the proceeds plus a bit more capital into sbsw, only a 0.6% position to respect the geopolitical risk. it’s supposedly very well managed, controls its geography with a private army, and for a potential extra pop has a lot of uranium hiding in its tailings.
    .
    speaking of uranium, i’m up to a 17% position in sruuf. i started buying in 2021. it went down and i sold in 2022, only to re-enter in 2023, when it was about $13 and change. i’ve added some on the way up, and it’s now $22.72. it’s been going sideways since its peak this past february, and i think it’s still got a long runway over the next 1-4 years. uranium is in shortage now that the excess produced by the downgrading of surplus warheads has run its course, and while sruuf has soaked up almost 65 million pounds of u3o8 [yellowcake]. kazatamprom[?], the world’s biggest producer, is unable to meet its contracted deliveries because of a sulfuric acid shortage, and cameco is a million pounds a year short of its contracted deliveries. it takes 4-5 years to bring new mine production online.
    .
    meanwhile, although the u.s. has only added 1 [or 2?] reactors in recent decades, china alone has 50 under construction. according to the world nuclear association there are a total of 60 under construction globally, and another 110 planned, mostly in asia. in the u.s., reactors keep getting life extensions as the utilities are desperate to maintain dispatchable baseload power. even the world green movement has finally awakened to the benefits of nuclear power, and at cop28 a bunch of countries including the u.s. declared their intentions to increase nuclear 30% by i forget when. bottom line, i expect an eiffel tower before new production comes online.

    1. Finster says:

      Thanks. I may have just been too impatient with IMPUY due to juggling too many positions. I’m getting a sneaking suspicion it may have bottomed, and its 6% yield could be a good fit for an income position – provided the dividend is secure – and in which case I don’t care what happens to the price.

      U was popular about twenty years ago. I remember a lot of buzz on The Daily Reckoning about it but never jumped in. I just didn’t have a feel for it, and in my experience that’s a recipe for poor trading. If I have a good feel for something I can buy low and sell high; otherwise I wind up doing the opposite. I think that while fission will be a part of the energy mix for quite a while, it’s not going to be a sustainable solution and will run into environmental opposition. I wasn’t aware of the Sprott fund, though … interesting find.

  6. jk says:

    if you want to get up to speed on the uranium story, listen to the discussion at
    .
    https://pracap.com/kuppy-and-mike-alkin-uranium-interview-at-the-2023-world-nuclear-association-symposium/
    .
    basically, for the last few decades no one in the nuclear power industry worried about getting fuel. warheads were being downgraded and there was a huge secondary market in surplus. also no one in the financial community was paying attention.
    .
    now utilities are putting out rfp’s asking for offers of fuel and not getting any offers.
    .
    the cost of the fuel is de minimus compared to the huge amount of capital invested in the facilities, and the facilities are gigantic paper weights if they don’t have fuel. so buyers are ultimately price insensitive. besides, they can always go to the utilities commissions and get rate hikes if their costs go up.
    .
    given mine production shortages, the long lead time for new mines, and growing demand, we are set up for a squeeze.
    .
    sruuf has no redemption mechanism [unlike phys]. it has a standing atm stock sale facility, so whenever it’s at a premium it sells more shares and buys more uranium. i don’t know if the utilities are using it to hedge their future needs yet, but i don’t believe there are futures, and so it would be a natural hedging mechanism for them. my own guess is that ultimately a consortium of utilities will buy sruuf whole, but i don’t think that happens for a while.

  7. jk says:

    the environmental opposition in the u.s. is why it is so expensive and takes so long to build anything here. i don’t think it works that way in china, or other developing markets.

  8. jk says:

    if you want platinum and palladium exposure without geopolitical risk, sprott has a closed end fund, sppp. as the move to ev’s stalls, car buyers – and therefore car makers- are turning to a more sensible solution: hybrids [and plug ins]. these require even more platinum group metals in their catalytic converters than straight ice vehicles. gas vehicles use more palladium, and diesel more platinum- or maybe it’s the other way around. in any event, there’s certainly a case for increasing demand for these metals.

    1. Finster says:

      Thanks. I’m using PLTM in accounts where yield isn’t required. The search for mining stocks like IMPUY was motivated by needing things that pay dividends to fit in income only accounts.

      The idea is the two ways to realize a return are to either sell or receive dividends. My income only accounts have a self-imposed buy and hold discipline, so everything in them must have yield. This division of capital and income objectives is explained more fully on the Model Portfolios page. Maintaining separate portfolios for each keeps clear how much is allocated to each and what each position is for.

  9. Finster says:

    “sruuf has no redemption mechanism”

    You mean I can’t get my yellowcake shipped to me?

    That would be a dealbreaker. I’d hoped to follow in the footsteps of ol’ “Pops” Finster. Used to spend hours playing around with U out behind the barn. Must’ve found it energizing; he’d come back late at night with a warm glow about him. Except one night he didn’t. Next day Mawmaw went out looking … couldn’t find him anywhere. For that matter, couldn’t find the barn.

    Most folks don’t remember that ‘cause it was the same night as the ‘quake of ‘32. But we never saw Pops Finster again. Nowadays every once in a while we go out to the shores of the lake where the barn used to be, build a fire, tell stories about ol’ Pops and gather up specimens to sell to the university. Maybe not the way he imagined, but we’re starting to suspect U might’ve turned out to be a fine investment after all.

  10. jk says:

    i was thinking of utilities buying via redemption. i think they will ultimately have to buy the fund outright.
    .
    but if you want the real stuff yourself…
    .
    https://www.amazon.com/Images-SI-Uranium-Ore/dp/B000796XXM/ref=sr_1_3ps%2C125&sr=8-3
    .
    my favorite review
    .
    4 star review
    .
    Ok for cleaning teeth, not so great for killing ants..
    .
    By Nero Goldstein in the United States on December 3, 2007
    .
    Picked this up for use in one of my kid’s ‘diversity’ projects in school (Great Success!), and stuck the leftovers in the cabinet next to the baking soda.
    .
    Ran out of toothpaste, and remembered how you’re supposed to be able to use baking soda to clean your teeth, so of course, I accidentally used this instead, and Wow! all I can say is, my teeth have never been cleaner! They sparkle, they tingle, and for some reason, they STAY clean now, no matter what. Highly recommended!
    .
    However, when I ran out of that fire-ant killer powder stuff, I figured I would try some for that too.
    .
    Big mistake!
    .
    Boy, it sure did not kill those ants!
    .
    Fortunately, those suckers get slower as they get bigger, so I have been able to use a shovel to take care of most of them, one at a time though, the sneaky devils.
    .
    And the darn trash man refuses to take them away..
    .
    I would have given this product 5 stars for the teeth and the project on embracing diversity, but I deducted one star because of the giant mutant ants.

  11. Milton Kuo says:

    I own physical platinum purchased and vaulted through BullionVault. I bought in 2018, 2019, and 2020. All I can say is that platinum has been something of a dog of an investment. Despite buying one-third of my position in the 2020 COVID lows, my total gain on platinum is about 28% (after the recent run-up in precious metals prices) before storage and insurance costs.

    Volkswagen’s diesel engine emissions fraud really did a number on the price of platinum. 🙂

    I continue to hold it because I don’t really know what else to do with the money and hope springs eternal in me that the platinum price can reach parity with the price of gold or maybe even touch something close to double the price of gold, a condition that existed for quite a few years in the 2000s.

    1. Finster says:

      From one long time platinum holder to another, Milton. I bought some Eagles and Isle of Mans about twenty years ago. Given the dollar depreciation since, platinum prices would need to have at least doubled just to tread water. It’s helped a little that I generally keep my platinum position in line with the size of my silver position. I regard it as one of the four basic monetary metals, copper, gold, silver and platinum, all having a history of use as money.

      They also have industrial uses too, falling on a spectrum of gold being the most monetary and copper being the most industrial. As you note platinum once reliably traded at a premium to gold on an ounce for ounce basis. Cultural references to platinum such as platinum records reflect that esteem premium.

      I’m not holding my breath, but I’m holding my platinum.

Leave a Reply

Your email address will not be published. Required fields are marked *