With the whole yield curve now inverted (see below), and 2s-10s yield curve most inverted since 1980s, the talk of inversions signaling recessions is growing louder and louder. This, to me, is simply baffling.
The case for linking inversions to recessions was always
simple. Indeed, it is more of an observation connected with somewhat sound
logic: Inversions occurred before all the recessions[1],
and there is reason why inversions could be reflection of collective wisdom
about coming decrease in interest rates below neutral due to coming recession
(and hence signal of coming recessions).
That is all fine. Where I get lost is how does this apply to
current inversions. For example, the 2s-10s inversion deepened significantly following
the lower than expected US CPI report two weeks ago. This report led markets to
(a) reprice the future path of federal funds, (b) correspondingly lower the
2-year yield, and also (c) lower the 10yr yield. Since (c) happened to a larger
extent than (b), we ended up with deeper inversion. On face of it, this might seem to somebody
like bad news causing deeper inversion, right?
Do not count me in that camp. To see why, notice that the
decrease in 10yr yield was different from the decrease in 2yr yield in that it mostly
was not about lower expected path for fed funds rate.[2]
Moreover, in so far as it was it was about expectations about future policy, it
did not reflect expectations that policy rates will move eventually below
neutral level, which is at the core of the signaling theory of yield curve
inversion. Rather it reflected expectations that policy rates will rise less above
neutral than was expected before. And if it was not about below neutral
expected future rates, it is hard to argue that it was in some reflection of
markets increasing their odds of recession, even though the inversion deepened
significantly. If anything, it is hard to find anybody who thought the news
were not good, as indicated by a positive stock market reaction. I am
therefore struggling to follow the people who say that this development to them
suggests risk of recession has increased.
Or take the most extreme example, the policy rate yield
curve, which inverted only now. Is this in any way further strengthening of a
signal of coming recession? Again, I struggle to see the argument. There are
two reasons why the policy yield curve inverted now: the drop in 10yr yield,
which I already argued was not a portend of coming recession; and increase in
fed funds rates by the Fed during the November meeting. Of course, the increase
in fed funds rate on its own can cause recession, but that is not the argument
of yield curve believers. Rather, they argument is “Hey, it inverted, it must
be a bad signal.” But if the inversion is caused by the central bank that increased
fed funds rate, as expected, how can anybody interpret it as a signal of
anything? Will it recession suddenly become much more likely on December 14,
when policy yield curve will invert even more following the next hike, compared
with December 13? I did not think so.[3]
So why are we having inversions if it is not because markets
are pricing lower future rates because of recession? In other words,
what do I say to somebody who might argue that long-term rates are always above
short-term rates, unless markets expect policy rates to decrease, which is typically
due to recession? Well, as you might guess, it is the typically, which is the
problem. This inversion is not typical in that it is caused by the central bank
itself. In other words, the central bank’s plan is for policy rates to follow
an inverted “roof-shaped” path – rising significantly and temporarily
above neutral before declining back to neutral.
This on its own should mean inversion, if bond yields are
expected average future short-term interest rates (aka the expectations
hypothesis). Therefore, the current inversions do not need to signal anything
about the financial markets’ recessionary beliefs, just that they believe Fed’s
intentions to go above neutral.[4]
And this is what makes current inversion different from previous experiences:
Back then, central bank was not hell-bent on going above neutral in fight
against inflation, rather, it was trying to find neutral. And this, I think is
an appropriate end to blog that has “folly” in its title: ending it with
variation on the biggest folly of all, “this time is different”.
[1] Of
course, the statistician in me wants to scream something about N<10, but
that is not the point for today.
[2] This
is of course unsurprising, because changes in expectations about future rates
rarely shift enough to move the 10yr yield, which is presumably the average
expected value of fed funds rate over the whole 10yr horizon. Rather, the CPI
report was catalyst for more broad repricing, which showed up as much lower real
10yr yield. Personally, I think it was in the spirit of coordination games a
signal that this is finally the time when everybody will stop worrying that
10yr yield will rise further, and hence signal for everybody to buy 10yr yield,
but that is purely speculation on my part.
[3]
Similar argumentation applies to the 3m-10yr yield curve, even though there
things are of course continuous.
[4]
Note that the standard rules of logic apply – I am not saying markets are not
expecting recession, or that recession will not happen, just that current
inversions do not imply that markets are expecting one (even if they might be).
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