The yield curve is dis-inverting rapidly. Here is how to analyze this important phenomenon.
Nothing better than a deep dive into the yield curve on a Thursday! Many are familiar with the yield curve slope as the predictor of recessions: the track record is almost perfect, and there are good reasons why.
An inverted yield curve often leads towards a recession because it chokes real-economy agents off with tight credit conditions (high front-end yields) which are reflected in weak future growth and inflation expectations (lower long-dated yields).
A steep yield curve instead signals accessible borrowing costs (low front-end yields) feeding into expectations for solid growth and inflation down the road (high long-dated yields).
But what people pay little attention to is how the combination of yield curve slopes and nominal growth regimes can influence asset class returns. See the table below for some examples.
1) When nominal growth is increasing and the curve is bull steepening In this environment the Fed is keeping policy accommodative while the economy does well – the attempt is at overheating the economy, often to recover from a slowdown.
The curve bull steepens: it reflects easy monetary policy at the front-end which is likely to heat up nominal growth (hence long-end yields higher). In this macro scenario cyclial stocks do particularly well: the combo of low financing costs at the front-end and a strong nominal growth backdrop is particularly favorable.
2) When nominal growth is slowing down and the curve is bull steepening (today) Here the story is different: lower nominal growth doesn’t help earnings, and a late-cycle bull steepening indicates pressures are emerging and the Fed is getting ready to cut. In this environment, cyclical stocks and commodities don’t do well.
Understanding the yield curve is crucial to become a better macro investor. The recent bull steepening which is happening late-cycle when nominal growth slows down doesn’t bode well for cyclical stocks. But most importantly it’s happening at an interesting macro juncture:
See the pattern:
1) Every recession since the 1970s was preceeded by a yield curve inversion 2) The timing between the initial inversion and the start of a recession varies: in the early 80s or 2000s recession it was as little as 12 months, while in 2008 it took 27 months (!) for the macro lags to appear 3) Today the yield curve has been inverted for over 20 months and counting.
A potential dis-inversion right here (green dotted line) would be the last step in the historical recessionary sequence The US economy is proving to be way stronger and stubborn than many expected. It caught me and many others off guard.
But remaining vigilant is important, and understanding yield curve dynamics in the context of nominal growth can make you a better macro investor.
References: Mr. Alf, Bloomberg, Reuters.