The Flattened / Inverted Yield Curve —With An Asterisk

 

In 2006, Capital Advisers (correctly) wrote that “Compared to past periods, the yield curve inversion we are experiencing is quite benign, so there need not be profound concerns that an economic recession will automatically derive from this phenomenon”. It wasn’t a hunch that made Capital Advisers write this, it was historical Facts, Math & Data:

“The yield curve inverted (negative 2yr & 10yr yield differential) eight times, for at least one month at a time, in the last 30 years…

The average duration of an inversion was seven months…

The average negative spread was 0.33% (33 bps)…

Dispersion of severity exist, for example, a mild one started June 1998 with an inversion lasting one month of 3 bps; and an inversion beginning Aug 1978 lasting 21 months getting to as much as 202 bps.

Conclusion: Not all inversions lead to recessions, there is ONLY a correlation between severe inversions leading to recessions.

Furthermore, not all recessions were preceded by inversions—between 1954 and 1966 there were three recessions but no inversions.”—Capital Advisers, 03/01/2006

Fast forward to 2018, one other point that should also ease concerns about this flattening yield curve (or any possible yield-curve inversion in the near future), is that this yield curve had an asterisk—because this was a yield curve while the Fed was sitting on $4.2T of bonds ($2.4T in Treasury bonds and $1.8T in mortgage-backed bonds) on its balance sheet. Removing those long-term securities from the bond market gave today’s yield curve a flattening ‘advantage’ over other yield curves of the past, so any comparison would be ‘unfair’.

Meaning that today’s flattening yield curve (and if it happens, an inverted curve), has an asterisk, because of bonds (Treasury Bonds); similar to that baseball that has an asterisk, because of bonds (Barry Bonds).

The issuer of dollars (the federal gov’t) has complete monopoly power over dollars and it mandates its banking agent (the Fed) with monopoly power over the ‘price’, or interest rate, of dollars to maintain price stability throughout the economy. The purpose of the Large Scale Asset Purchases, so-called ‘QE’, begun by the Fed in November 2008, was to intentionally drive long-term bond yields lower (and the Fed also lowered the short-term target interest rate to ZERO percent the next month). So while nobody knows where long-term bond yields *should* be right now, we can all safely assume that long-term bond yields would today be higher right now if the Fed never bought and was not still engorged with all those long-term bonds.

Which is why Fed Chair Powell probably isn’t too concerned that this yield curve, with that asterisk, is flattening.

In addition, the reason why Fed Chair Powell probably isn’t losing too much sleep over the thought of a possible yield curve inversion is this:

Of the $2.4T of the SOMA (Fed balance sheet) Treasury bond holdings (one of two bullets in its double-barreled bazooka), approximately 92% have a 10-year maturity or more. By merely hinting that the Fed was even considering an intra-meeting move and selling those long-term securities back to the secondary bond market (‘dumping’ them on the ‘street’), that yield curve flattening / inversion is gone in 15 nanoseconds.

 

Thanks for reading,

 

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P.S.

01/23/19:

NEW YORK: “Legendary former NY Yankees closer Mariano Rivera made history today by becoming the first player ever to be unanimously voted into the National Baseball Hall of Fame. Rivera’s last Major League Baseball appearance was on September 26, 2013.* 

 

Asterisk: *While Rivera celebrated, Barry Bonds, who last played in 2007 for the San Francisco Giants, was once again left out of contention, finishing well short of the required 75% of votes to earn induction.”

 

P.S.S.

03/22/19:

The 10yr Treasury note breaks the 52-week low of 2.44% and prints a yield of 2.42% resulting in a 3MO Treasury bill / 10YR Treasury note yield-curve inversion—for the first time since the financial crisis in 2007.

“I want to point out a few things. 1) Never in history have we increased deficits with an inversion. 2) The average yield on the 10-year during the last nine inversions was 6% and today the 10-year yields less than half. In other words, yield inversions in the past were a very good indicator of a recession (because the drop in long-term yields removed the incentive for banks to lend); but when rates are already so low and then there’s an inversion, it’s not like there’s as big of a drop of an incentive for banks to lend like in the past. I don’t suggest that these facts forever stave off recession, but surely there is a difference with this inversion.”—MineThis1

I agree with MineThis1. It’s an inversion with an asterisk because it’s an inversion with a Fed that just told the world (two days ago on 03/20/19) that, rather than fully ‘unwind’, the Fed intends to keep holding on to $3.5T of long-term bonds (17% of GDP) on its balance sheet. Meaning that the Fed will still be a huge buyer of bonds in the secondary market in order to maintain that $3.5T amount—and while not planning to raise rates for the rest of the year. What do you think the ‘buy side’ players (Wall Street parlance for bulk buyers of long-term bonds like pension funds and insurance companies that seek to lock-in yield for their clients looking for fixed-income products) are going to do when they figure out what that means? What do you think Asian and European investors (looking at Japan and German 10-year bonds in zero or negative territory) are going to do when they figure out what that means? Furthermore, adding fuel to that fire, what do you think the ‘sell side’ intermediaries (Wall Street bond traders) are going to do when they figure out—what everybody else has just figured out—what that means?

This inversion is more of a signal of front-running (and less of a signal of recession).

Another way of putting it, rather than signalling a coming recession, this inversion is more like another ‘taper tantrum’.

In 2013, the Fed hinted that it would start to scale back stimulus measures, which triggered a sell-off in the prices of US Treasury bonds—the so-called ‘Fed-QE-Taper tantrum’—because the Fed was basically telling the bond market that the Fed would soon not be propping up the price of long-term bonds by not adding to their bond holdings on the Fed balance sheet as much as they previously hinted they would.

Fast forward to last week (03/20/19), in their FOMC Statement, the Fed said that they would start to scale back the unwinding measures. In addition to saying that the Fed would not hike rates in 2019 (as much as they previously hinted they would), the Fed basically told the bond market that they would soon not be subtracting from their holdings on the balance sheet (as much as they previously hinted they would, either). That triggered heavy Treasury bond buying, which raises the prices of long-term bonds, which lowers the yields—which you could call a ‘Fed-Unwind-Taper tantrum’.

In both cases, even though the Fed said the economy was strong and that the outlook was good, the markets had ‘tantrums’—meaning everyone initially overreacted. In 2013, everyone at first thought that the Fed contemplating the end of Large Scale Asset Purchases (LSAP)—aka Quantitative Easing (QE)—was bad news for the stock market. The reason why, was because everyone had all along been told by The Very Smart people over the airwaves that stocks were ‘artificially pumped-up by the Fed’s QE’ and now that QE was ending, stocks would therefore collapse (on those rumors). Then everyone figured out that the Fed simply saw the data coming in and knew the economy was doing well, so that’s why the Fed was ending QE and then everyone bought stocks (on that news). 2013 ended up being great for stocks—the S&P 500 posted its largest annual jump in sixteen years and the Dow its biggest gain in eighteen. So the lesson hopefully learned by everyone in 2013 was that our monetary system (the US economy) is now in a post-gold standard, post-LSAP world.

Recently, we are now seeing an overreaction to yield-curve inversions. Don’t misread the Fed-Unwind-Taper as being bad news for the US economic outlook. All it means is that the Fed has decided upon the approximate amount of bonds (assets) that it needs to keep on its balance sheet—in order to maintain that approximate amount of reserves (liabilities). The reason for needing those large amounts of reserves is that, unlike before the credit crisis, banks today—especially the largest financial institutions—need a lot more reserves held at the Fed because banks today now have much larger liquidity requirements (aka new ‘macro-prudential’ regulations) that they must meet in order to avoid getting ‘too big to fail’. The lesson being learned in 2019 (including by the Fed itself since this is all new terrain) is that our monetary system is now in a post-gold standard, post-LSAP, post-stress test world. 

 

 

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