It’s a long time since we’ve been so inverted. The explanation might not be what you think.
Conventional wisdom says yield curve inversion is a harbinger of recession — time is supposed to have value, so paying more to borrow for shorter periods makes very little sense. And as we type, the US 2-year yield has climbed to its highest level relative to the 10-year since the 1980s. Shorter-dated Treasury yields are nearly 87 basis points above longer-dated notes.
Yet executives aren’t convinced the US will go into recession this year, jobs data has been strong and inflation might’ve crested. Each improvement in the US growth outlook in recent weeks appears to have been matched a deepening of the yield curve across all segments. What gives?
According to Goldman Sachs, that’s because the bond market is wrong and we’re living in the past.
“The most compelling reason for the discrepancy is the presence of a strong prior among investors about R* [the neutral long-run rate of interest that balances the economy] being low and similar to estimates from the last cycle, despite the very different nature of the current cycle,” it told clients.
In other words, investors think that the Fed will have to make sharp rate cuts in the future, because rates were low for a long time before now. Many readers will remember old-timer bond traders arguing in 2012 that rates were too low, mostly because rates were higher when they were young. Goldman says that investors are now doing that in reverse.
Remember, the yield curve can be best understood as a probability-weighted average of policy expectations. For short-term Treasuries, inversion can be “substantial” whenever the Fed is expected to cut rates in the near term. But the gap will look the same whether the cause of those rate cuts is a recession or a so-called soft landing.
Meanwhile, for long-dated bonds, rates should stay higher when the consensus says recession can be avoided; investors will demand more compensation for the risk that steady (or high) inflation will erode their principal over that time period.
What’s happening now is that, following the Fed’s short-sharp-shock approach, there’s an odd certainty that long-term yields will return to low levels:
As a result, all the usual duration comparisons have stopped working. The two ends of the Treasury market’s pantomime horse are no longer moving together.
Here’s how: strong economic data implies that the Fed will wait longer to cut rates. That expectation causes short-term rates to rise. But long-term yields have been “sticky,” Goldman says, because investors assume that they will revert to their post-GFC mean. Because of this, a deepening inversion seems to “have the opposite implication for recession odds than commonly ascribed,” Goldman says.
But that raises the question of whether the “stickiness” in long-term yields is reasonable to begin with.
To guess whether it is, Goldman uses a nominal yield curve that’s framed around some complicated fair-value methodology you can read about here. Its adjusted yield curve finds that while the mid-range is approximately fine versus the natural rate and the long end is slightly steeper, the front end remains extremely inverted:
Why tho?
First, markets may be assigning higher recession odds down the road than we think likely, which would entail more Fed easing than the consensus economist forecasts. But higher recession odds and anticipation of more easing over the next two years should produce a steeper 2s5s curve, all else being equal, unless, of course, the Fed were to cut the policy rate, and keep the rate low for a very long time. This does not strike us as particularly satisfactory, given that even if a recession were to materialize, we expect it would likely be shallow. Indeed, at least from a historical consistency perspective, it is somewhat abnormal, as evidenced by the clear discrepancy between the model estimate and the observed curve value.
A second, more obvious explanation, is that investors are anchoring long run rates to a different level than our model. In our model above, we used (real) potential GDP growth as an anchoring device for the policy rate; investors’ real rate anchor would have been nearly 150-200bp below this level for the model estimate to match the current level of inversion in the 2s5s curve. This would mean an assumed R* of 0-50bp, roughly in line with what was commonly believed to be appropriate pre-Covid.
When guessing long-term rates, investors have been suffering both from recency bias and credulity about Fed guidance. That “strongly suggests” the current inversion “comes not from high recession odds or inflation normalisation,” but investors’ reluctance to adapt to the New New Normal, says Goldman:
Investors appear to be wedded to the secular stagnation, low R* view of the world from the last cycle. We believe this cycle is different, with an economy that can support a higher long run real rate than currently assumed. [ . . . ] If the low R* view is correct, the Fed’s policy stance would indeed be substantively restrictive, and we will likely have a decidedly worse growth outcome than we currently anticipate. If, on the other hand, our economists’ baseline for a still robust economy comes to pass, it will be hard to argue that the Fed has been severely restrictive, and investors will likely update their long run rate priors, thereby moderating inversion to more ‘typical’ levels.
Or, this could be an example of the “this time it’s different” argument that invariably shows up whenever the yield curve inverts, when things are almost never actually different. Anyone’s guess, really.
Source: Economy - ft.com
