Friday, September 8, 2023

Kelly Evans: The yield curve isn’t broken...yet

By Kelly Evans, CNBC

The yield curve is useless! They exclaim. The recession should have been here by now! No, no. The recession is not late yet. And if it doesn’t show up for another three or even six or nine months, that wouldn’t be all that unusual by historical standards.

Looking back over the past seven decades, yield curve inversions have occurred anywhere from seven to twenty-five months before recessions began. That’s according to research from MKM’s Michael Darda. The average is fourteen months, and we are currently in month thirteen since the one-year Treasury began yielding more than the 10-year, which is the preferred metric for many professionals to watch.

So if the recession doesn’t begin in the next month or two, then the lag is longer than average. But still not unprecedented! And given the dual supports of massive fiscal spending and the Fed balance sheet swallowing up much of the paper losses in the financial system right now, it’s little wonder we’re seeing a delay.

“There does not appear to be a pattern for lags becoming longer or shorter over time, only that there are lags,” Darda wrote to clients yesterday. And while other forecasters, like Goldman’s Jan Hatzius or Jefferies’ David Zervos, remain optimistic the economy will avoid a sharp downturn, Darda (along with a select few, like Michael Kantrowitz and Nancy Lazar at Piper Sandler) maintains that’s unlikely. “There has never been a soft landing after an inversion as deep and persistent as the one associated with the current Fed tightening cycle,” he warns.

Now, critics like to dismiss the yield curve’s usefulness precisely because its lags can be so long and variable. But that misses the larger point. For the Federal Reserve in particular, which is tasked with trying to set monetary policy to match these long and variable lags, its message ought to be crucial. And that message continues to be that monetary policy is too restrictive right now, even as officials continue to talk about the prospect of additional rate hikes or the need to keep rates “higher for longer.”

And for investors, there is especially reason to watch this long leading indicator carefully. Markets on average have rallied 10% after yield curve inversions. This time, as in both 1989-1990 and 2006-07, we have rallied more than 20% so far post-inversion. But as Darda notes, “even in those cases, the post-inversion rallies were more than wiped out going into subsequent bear markets/recessions.”

It is through this lens that many would view the high yields being offered on bonds and cash right now as the deal of the century. The market continues to doubt that rates will truly remain “higher for longer”-- five-year breakevens show expected inflation averaging just 2.24% in the coming years, barely higher than the Fed’s 2% target.

And we can only hope, because if we do have a recession and a “hard landing,” the government will no doubt be tasked with stepping in to support the economy. The trouble is, we’ve never had debts and interest rates this high at the same time before, and the deficit is already large going into what could be a downturn. The fiscal space to come to the rescue, in other words, is tighter than in the past. A sharp decline in interest rates would certainly offer some breathing room, albeit as the flip side of a deteriorating economy.

All I’m saying is it would be nice to avoid the messiness--and millions of job losses--that would come with a hard landing. And we are really now just entering the window that will determine whether this seeming economic resilience will really continue.

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