This Multi-decade Recession Indicator Continues Blinking

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In today’s edition, we delve into the abyss of bond market messaging.

When it comes to the bond market, the smartest market, there is a plethora of forward messaging views that can be extracted from the wake that is left behind from the trading operations of bond market participants.

There is a treasure trove of information offered from these participants, and yet, as is always the case, none offer guaranteed accuracy, looking forward, regardless of how accurate their historical track record has proven to be.

Admittedly, for those uninitiated in bond market lingo, this topic can seem strange as well as complicated on its surface. For our part, we will stay as high-level and as general as possible so as not to drill down too deeply into the topic, which can easily add confusion.

In addition, fret not; this can be as easy as simply viewing the multi-decade picture that we share below and letting it speak for itself to you.

Treasury securities come in various Maturities

The U.S. Treasury offers bills, notes, and bonds in financing the public debt.

Keeping this high level, these securities come in differing maturities upon issuance.

They can be as short as 90-day Treasury bills or as long in maturity as the 30-year Treasury bond.

Depending on where the security fits within the maturity spectrum, it depends on what impacts its pricing by bond market participants. For example, 90-day Treasury bills are very short-term and bring with this short maturity limited risk. These are often referred to as “No-risk T-bills.”

Conversely, 30-year Treasury bonds bring a wealth of risks inherent to their long maturity, and with this, participants process a plethora of information/data when pricing them via their trading operations.

For example, price inflation is a major input of consideration by bond market participants when participating on the long end of the treasury maturity spectrum. Interestingly, during periods of price inflation, they develop their own slang known as “certificates of guaranteed confiscation.”

This speaks to how price inflation, if it is around long enough, can easily eat through capital deployed in long-end treasuries as the hidden tax of price inflation returns to the holder of such bonds capital that is less than invested when adjusted for price inflation.

This is why long-end treasury maturity bond participants demand a higher yield (interest rate) when pricing these longer maturity treasuries within the bond market.

They achieve this by selling these bonds, and when done en masse, these bond prices move lower, and hence, their yields increase to compensate for the higher inflation or for whatever other risk they may be assessing and hence, are pricing into the security.

Taken one step further, an important step, btw, this is one reason why the Fed has no control over the longer end of the maturity spectrum for bond market securities when they adjust their Fed Funds Rate.

This is how and why, as we have shared in numerous editions over recent years, when the Fed cuts rates, we can actually see longer-oriented interest rate offerings in the economic system increase as the Fed is cutting. Think mortgage rates as one example.

With the above as a brief treasury security backdrop, let’s begin to put some meat on the bone for today’s edition.

Keep It Simple Stupid (KISS)

Keeping it simple, as described above, longer-maturity treasury securities can be expected to pay a higher interest rate compared to short-end maturities in light of the increased risks that come with a longer maturity. A no-risk T-bill is expected to yield less than say, a 10-year treasury note. Easy peasy.

When this is not the case, when shorter-end treasuries yield a higher rate than longer-end treasuries, this is then referred to as an inversion.

Specifically, it is referred to as an inverted yield curve.

This simply means longer-end treasuries are actually yielding a lower interest rate than the shorter-end treasury securities. Think of it as being upside-down from what is the norm.

In the name of brevity, as well as reduction of complication and confusion, we will not delve into the myriad of storylines that can make bond market participants as a whole move into an inverted yield curve. If we keep this very brief and simple, it is bond market participants’ messaging of an expected increase in recession risk.

The timing of this implied recession risk does not come with a time period.

What we know is when the yield curve inverts, bond market participants are signaling an increased concern of downstream recession risk. Downstream as in some unknown time somewhere down there on the timeline.

With this, when the curve inverts, it is (seemingly) customary for talking heads to run to the closest microphone, emphasizing recession is imminent. That would be incorrect, but nonetheless they do, and rest assured, well into the future they will continue to do so, using history as a guide.

The real risk of an inbound recession is when the described yield curve inverts for X time, then uninverts.

It is the uninversion, or said differently, it is the reemergence of an upward-rising yield curve again, after having been inverted, that brings with it the recession risk, per bond market messaging.

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Above is a 35-year chart dating back to 1990. The red horizontal line denotes the zero marker whereby when the yield curve inverts (think becomes abnormal), it moves to or below the red line.

Our black arrows point towards every recession we have experienced since the inception of the above chart. The recessions noted by the black arrows also line up with a notable uninversion of the treasury yield curve.

To the far right, our current experience includes a question mark asking if this time will prove as accurate as the 35-year storyline for this message from treasury market participants.

As an important aside, to add detail, the above is a 10/2 curve spread. This means the above represents the difference in yields between the longer-term 10-year treasury note and the short-term 2-year treasury note.

When the above went below the red line, this curve inverted, meaning the 2-year treasury was yielding a higher rate than the longer-dated 10-year treasury. This is upside-down from the norm, or using bond market lingo, the curve inverted.

Historically, the uninversion occurs in light of the Fed cutting rates at an increased pace as they respond to something in the economic sphere. The shorter-term 2-year note reacts far more to the Fed actions, being a short-term instrument, than what the longer-dated 10-year security does.

With this, the uninversion kicks into gear and proceeds upward, such as we have seen throughout the decades displayed, to include our current period.

Is this an infallible indicator? No, nothing is when it comes to economic forecasting.

What we can offer is this indicator has proven spot-on over the decades displayed above. We are doing it again, or more accurately, bond market participants are doing it again. This will prove to be quite interesting as near-term weeks and months unfold.

For our part, we have been monitoring this chart for the previous 3 years as inversion appeared likely. The talking heads, as the inversion unfolded, assured us economic recession was upon us. Okay, we will wait for the uninversion, whenever that will be, and then see what occurs, was our in-house view.

Viewing the above history, you can see why we would have such a conclusion in real-time, dating back to recent time.

Next up in this process is to watch the Fed cut rates and the long end of the bond market’s response to those expected cuts. Our eyes are glued to the bond market and the many relationship messages they share from their trading operations.

I wish you well…

Ken Reinhart

Director, Market Research & Portfolio Analysis