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Good morning. FedEx, which recently released its earnings report, is facing difficulties in managing cost inflation. The company is cutting costs to safeguard profitability due to weak demand, according to the CEO. Following a lackluster day for stocks, FedEx’s shares fell by 3% after hours yesterday. It appears to be a slow start to what could be the new bull market. Email us at [email protected] and [email protected].
Analyzing the yield curve: Yesterday, we emphasized that betting against the three-month/10-year yield curve is not advisable. Upon further reflection, we believe that this simple bet, in favor of or against signals of a recession from the rates curve, has been the key factor influencing markets for the past 18 months. It holds more significance than any other financial and macroeconomic debates. Given the changing factors related to this bet, it is worth revisiting the debate. Let’s start with the familiar chart of the curve over the past four decades:
In the last 40 years, all five inversions accurately predicted recessions without any false positives. While correlation doesn’t imply causation, a compelling explanation is needed to infer causation. In this case, the explanation is quite simple and powerful. A curve inversion occurs when the Federal Reserve raises short-term interest rates above the economy’s neutral interest rate, which neither fuels inflation nor increases unemployment. Although the exact neutral rate is unknown, long-term interest rates serve as an approximation in the market (adjusted for inflation). When short rates significantly exceed the neutral rate, it slows down the economy and eventually leads to a recession. This is partly because the impact of rate policy on the economy is unpredictable and has a lag, causing policymakers to tighten rates for longer than necessary.
Considering this explanation, the depth of the inversion becomes crucial. A large gap between long and short rates indicates tighter policy. It is worth noting that in 2023, the inversion has reached historically deep levels, as shown on the chart. However, various market signals, such as stock prices, credit spreads, and volatility, seem to be disregarding the inversion. Surprisingly, certain parts of the economy are defying the curve by showing signs of strength. One recent example is the significant increase in housing starts. This raises the question of whether this highly sensible and reliable indicator could be wrong this time.
There are two main ways to dismiss the yield curve’s validity in mid-2023. The first approach suggests that we are in an unusual economic cycle. It posits that there is a level of tightening (X) that effectively reduces inflation and another level of tightening (Y) that pushes the economy into a recession. Unlike previous cycles, the argument is that X is now smaller than Y, and the Federal Reserve will stop at X.
One viewpoint is that the current inflation is a delayed consequence of a series of supply shocks working their way through the economy. Excess demand from stimulus packages plays a negligible role. Tightening policy, designed to curb demand, becomes almost unnecessary. Consequently, X is smaller than Y. This viewpoint is supported by some, including my colleague Martin Sandbu.
Another version of the “X is less than Y” narrative suggests that the labor market was exceptionally tight even before inflation emerged. This means that the Fed can reduce significant demand before many people get laid off. Mass layoffs typically define a recession. This view is similar to the one held by Chris Waller, a Federal Reserve member, whose paper on job openings offers a comparable argument. Instead of job openings, one can substitute extraordinary household savings for resilient employment, and their lasting effect can bridge through inflation until policy loosens. Campbell Harvey, a professor at Duke University and director of research at Research Affiliates, previously held the belief that X was less than Y and that the Fed would accurately time the tightening, as recently as January this year. His previous view was influenced by a strong job market and a well-functioning financial system, particularly when compared to the 2008 recession. Interestingly, Harvey is credited with first demonstrating the connection between inversions and recessions back in the 1980s. However, his current stance has changed. He now believes that inflation is decreasing rapidly and that more rate hikes will jeopardize the economy. In short, he trusts the curve.
The second approach to questioning the yield curve’s validity is suggesting that long-term rates have become significantly distorted, meaning they are too low. Consequently, the curve no longer provides a reliable signal. Some blame the Federal Reserve’s bond-buying programs for these distortions. However, the argument only requires showing that 10-year bond yields are mispriced and should be higher, resulting in a shallower “real” yield curve.
Michael Howell of CrossBorder Capital, for example, points out the vanishing term premium in Treasuries. The term premium measures the difference between long rates and the expected trajectory of short rates. It compensates investors for the risk associated with potential changes in rate outlook. Currently, the term premium is negative (based on estimates from the New York Fed) and near an all-time low. A negative term premium is peculiar, and Howell suggests that it indicates long-dated Treasury prices are driven not by rate fundamentals but by demand for long-term risk-free securities used as collateral. Consequently, the curve provides distorted signals.
However, Unhedged believes that the yield curve’s signals are accurate and that a recession is imminent. Despite the hazards of short-term economic predictions, we hold this view for three reasons:
1. The sources of excess demand that we are witnessing, such as high consumer savings and a tight labor market, may prove temporary. Many economic indicators appear strong until the moment a recession hits. In other words, Y tends to be smaller than initially perceived when faced with real pressures.
2. The difficulty in timing accurately is why the Federal Reserve often tightens monetary policy excessively. This pattern makes it unlikely for the central bank to time the tightening effectively this time.
3. While we acknowledge that 10-year yields may be distorted, long-term rates have been steadily decreasing for a significant duration across all regions. The neutral rate may be higher than 3.7% (the current yield on the 10-year Treasury), but not substantially higher.
We anticipate a recession within the next year, with hope that it will be mild.
Certainly, many readers may disagree with both the characterization of the yield curve and our faith in it. If you are among those who disagree, please send us an email.
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