Time for some fire and brimstone.
First up, University of Michigan’s Consumer Sentiment chart, which has dropped down to 2008 Global Financial Crisis levels:
Inflation and unaffordable housing probably has a lot to do with this.
This is a gauge of the “real economy,” and the the real economy is in bad shape right now.
Next up, the Buffett Indicator, aka total market cap to GDP ratio, which is not only at all-time highs but significantly higher than it has ever been in the past 50 years:
The stock market is now 190% of GDP.
At the peak of the Dot Com bubble, it was 141%.
And it looks to be rolling over.
Now let’s look at the treasury yield curve, which is close to inverting. This means that short term interest rates are nearing the point where they are higher than long term interest rates. It means a recession is drawing near:
From the article:
Let’s start from why I think the yield curve will invert.
Upward sloping yield curves are generally associated with markets expecting a healthy expansion down the road: why?
An upward slope implies that short-term borrowing costs are low enough to ensure decent long-term nominal growth.
Also, in this macro backdrop investors demand a higher compensation for holding riskier long-term bonds rather than simply rolling over the ownership of short-term bills – that compensation is called term premium.
Today though, the macro environment doesn’t fit the picture above – quite the opposite actually: I argue the yield curve is likely to invert soon.
For the curve to invert though, long-end yields also matter: what about them?
Long-end bond yields = long-term nominal growth + term premium.
Poor demographics and stagnant productivity trends already weigh on long-term nominal growth prospects. On top, since summer 2021 we are witnessing a cyclical slowdown in growth impulse and now the Fed is on a mission to tighten financial conditions and increase short-term borrowing costs for the private sector: prospects for future nominal growth aren’t looking great.
Also, term premium is unlikely to increase: the uncertainty around future growth outcomes is not that high (it will suck) and hence the marginal compensation investors require to own long-term bonds in such a macro backdrop is pretty low.
Basically, long-end bond yields are going nowhere (or lower) while short-end bond yields shoot up to reprice an incrementally more aggressive Fed tightening cycle.
Up to the point when the yield curve inverts.
Yes, but what yield curve exactly?
The OIS swap curve – I like to look at the 5y-30y slope in this curve.
I know, it sounds complicated but it’s not: bear with me.
Most financial commentators look at various slopes in the Treasury yield curve to determine whether it’s inverted or not, but that’s not the correct way to do this.
Investors buying bonds are compensated with a bond yield that should cover both interest rate risk and credit risk.
A common mistake is to include the credit spread component in the assessment of yield curve slopes – it unnecessarily pollutes the analysis.
Instead, our focus should be on what market participants expect for the short-term and long-term path of the purest risk-free rates instrument: Fed Funds rates.
OIS stands for overnight index swaps and they are are perfect for that.
For instance: in a 5y US OIS swap, you receive a fixed 5y rate in exchange for paying the overnight Fed Funds rate on a daily basis over the next 5 years.
Basically, OIS swaps tell you where the fixed income market consensus expects Fed Funds rates to move over a fixed period of time (more here).
And yes, I am telling you Treasury bonds trade at a (credit) spread to OIS swaps – I will cover this and other topics in depth in a Bond Market 101 article.
I use the 5y-30y slope: the average length of a Fed tightening cycle tends to be historically around 3-5 years, while 30y yields reflect long-term expectations for nominal growth and term premium.
It’s now at 16 bps only (spoiler: the same slope on the Treasury yield curve would say we are ‘‘still’’ at 46 bps, quite a ‘‘healthy buffer’’ if you don’t look at the right curve).
OIS swap rates are not easy to find online unless you have an expensive Bloomberg terminal – but don’t worry: you can follow me on Twitter for regular updates.
Cool, now you know why I expect [the] yield curve to invert.
But who cares about yield curve inversions? Well, you should.
Inverted yield curves not only predict sharp economic slowdowns, but they also actively contribute to them.
Unfortunately, my OIS swap data goes back only to 2011.
For a more historical overview, we need to use the ‘‘credit spread polluted’’ Treasury yields, and the best way to reduce this pollution is to use the 2y-10y slope as long-end Treasury credit spreads tend to be the heaviest across the curve.
The Chicago Fed shows a very famous relationship: inversions in the 2y-10y slope of the Treasury yield curve is a solid indicator of sharp economic slowdowns ahead.
I am going to go a step further here and briefly explain why an inverted yield curve actually contributes to the slowdown, rather than only predicting it.
As explained here, we often overlay cyclical growth to the poor structural growth trends using leverage – this ‘‘kick-the-can-down-the-road’’ system is sustainable only if (real) borrowing costs are cheaper and cheaper to facilitate refinancing and marginal access to new credit.
When the yield curve is inverted, the marginal cost of refinancing and accessing new credit short-term increases and often breaches the equilibrium levels required to keep the system afloat – this increases the hurdle for the private sector to access credit.
As long-term growth prospects are poor, an already indebted private sector looking at more expensive borrowing costs might even think of the ‘‘true evil’’ – deleveraging.
A vicious circle therefore unfolds: restricted/more expensive access to credit in an already slowing and poor long-term growth environment leads the private sector to be more defensive, which compounds on the already ongoing cyclical slowdown.
An inverted curve doesn’t only predict slowdowns, but it often contributes to them.
When it comes to inversions, the right yield curve to look at is the Overnight Index Swaps (OIS) curve as it doesn’t pollute the analysis with credit spreads.
The slope of the 5y-30y OIS curve is likely to invert soon.
Today, it trades at a meagre 16 bps and Powell didn’t remove the hawkish Fed tail risks (e.g. 50 bps hike in March or hiking at every meeting) and validated the aggressive hiking cycle pricing amidst a clear slowdown in economic growth impulse.
This matters a lot, as yield curve inversions not only predict but they actually contribute to sharp economic slowdowns: as refinancing credit becomes prohibitively expensive today while markets already price in poor expectations for long-term growth, the economic engine actually slows down and a vicious circle unfolds.
That about sums it up.
Finally, we’ll look at this video by Meet Kevin on YouTube, where he debunks the idea that if the economy were really in bad shape, we’d see the unemployment rate start going up.
Now I’ve gone in depth about why the official unemployment figures are not at all representative of the actual health of the labor market, and that the actual US labor market is in terrible shape, but that’s kind of irrelevant to our purposes here specifically.
The point here is that if you’re waiting for the official unemployment rate to start going up for confirmation that the economy is entering a downturn, you’re behind the curve.
Unemployment is a lagging indicator, not a leading indicator. By the time unemployment starts going up, we’re already in the downturn.