Recession! Does the yield curve really predict it? What does history tell you?

One of the most relevant issues at present is the U.S. yield curve. It has been flattening throughout 2021 and so far in 2022 and recent weeks, this flattening has been increasing. In one of its most popular versions, the curve representing the spread between 2-year and 10-year bond yields has fallen to a staggering -0.20%. This is a level I haven't seen since late 2000 at the height of the dot-com bubble.

Below, we will show a chart pointing to the inversion of the yield curve (red arrow) before recessions. The shaded area) from 1980 to 2017:

Now, we will show a graph with the current situation:

This "late 2000s" reference alone raises concerns among some investors, who see the low spread between the short and long end of the curves as a sign of financial and economic stress soon.

But there is a basic misunderstanding surrounding the yield curve:

  • Thinking that an inversion of the yield curve, it.Yes., that the yield on the 2-year bond is higher than the 10-year, is a sign of a recession and impending bear market.

An inverted yield curve - or about to invert - is a sign of a recession and bear market.

As we saw in the first chart, the yield curve tends to invert or fall below 0 before a recession. And as we see in the next chart, the curve tends to invert before the onset of a bear market.

The problem lies with the nuances. While this is broadly true, we need to understand that the mindset of yield curves usually begins well before the bull market ends. It is one thing to look at a chart spanning five decades like the one above and another to look at the data more closely to see that there is usually a significant interim between one event, the inversion of the curve, and the next, the onset of the bear market.
For example, the last inversion of the U.S. The yield curve began in January 2006 and the bull market in the S&P 500 would continue until October 2007. That is 22 more months in which the market appreciated by 22%.

In 2000 it was a more accurate signal. In February of that year, the curve inverted and the S&P 500 would make its cyclical peak just one month later after rising an additional 7%. From then on, a powerful bear market would begin that would last until October 2002. However, just a year and a half earlier, there was also an inversion of the yield curve that brought neither a recession nor a bear market. So, in that period, we have to note a very accurate signal and also a "wrong" signal.

And to finish with examples from the last three decades, the yield curve began to be inverted in December 1988, but the S&P 500 would continue to appreciate until July 1990, no less than 19 months later in which the index would rise 33% before beginning that year's brief bear market.

Looking at these three decades we see that, out of four signals, one was wrong (25%), one was very accurate (25%) and the other two were positive signals of recession but very early (50%). In other words, we conclude that the yield curve is ahead of recessions, but that it is not a perfect signal, much less an automatic sell signal. If we had sold in December 1988, we would have missed out on a 33% rise, all to avoid a bear market that would reach its trough at a higher level than that in December 1988.
For all these observations, worrying right now that the yield curve is flattening is overdone. It is a normal occurrence as the economic cycle matures and does not mean much more.
Not content with this, AXL Capital Management has extended the study period and found the following:

The conclusions we can draw from the graphs shown are very clear:
The average period of time between the inversion of the yield curve and the onset of the recession has been 11 months, a figure that has ranged from 5 months in 1973 to 16 months in 2006.
The average return of the S&P 500 from the inversion of the yield curve to the onset of recession has been 2.8%, although this figure has varied considerably (-14.6% in 2000-2001 and +16.5% in 2006-2007).

The drawdowns suffered by the market from the peak reached after the inversion of the yield curve to its cyclical low were as follows:

-36.1% between November 1968 and May 1970.
-48.2% between January 1973 and October 1974
-17.1% from February 1980 to March 1980
-27.1% from November 1980 to August 1982
-19.9% between July 1990 and October 1990
-36.8% between March 2000 and September 2001
-56.8% between October 2007 and March 2009

Could the interest rate curve invert without a recession?

The answer is yes. As we see in the graph below, between the years 1965 and 1967, the yield curve inverted, but there was no economic recession. What the market was not spared, however, was a 24% drop between February and October 1966.

Therefore, if history is any guide, we are practically doomed to suffer an economic recession and, probably, a new bear market.
But if you have noticed, the recession usually coincides more closely when the FED decides to lower the benchmark interest rates, causing the spread of the 10 and 2-year bonds to become positive again, that is where the risk of recession and bear market is more latent.
If the statement in the previous paragraph is true, then when does the market expect a cut in interest rates (taking into account that the FED has not yet finished raising them)?

Peak Inflation
Signs are accumulating that the pace of price increases has peaked and will moderate further in the coming months.
The core consumer price inflation index, which excludes volatile food and energy prices, cooled to an annual rate of 5.9% in June, marking a slowdown from the 6.0% rate seen through May.

As seen in the chart above, the core CPI index has slowed for three consecutive months after peaking at an annualized 6.5% in March.
With crude oil and gasoline prices falling sharply since mid-June, headline CPI inflation is forecast to slow in July.
And it's not just energy-related commodities that are well below their peaks; prices for wheat, corn, soybeans, barley, oats, coffee, orange juice, and even chicken wings are down at least 20% from their recent highs, adding to evidence that food inflation is moderating.

As such, the reduced CPI rate could provide the Fed with another catalyst to begin cutting rates again early next year.

The market expects a rate cut in the first quarter of 2023.
Given our view that inflation will continue to slow for the remainder of the year, combined with growing expectations of a recession, markets are increasingly leaning toward the possibility of a dramatic change in Fed policy in the coming months. The market is now pricing in a full rate cut in the first quarter of next year as the Fed battles the recession it created.

Consensus is also growing among most Wall Street banks that the Fed will end its current rate hike cycle at its December meeting in response to lower inflation and recessionary conditions.

AXL Capital Management expects macro indicators (GDP, employment, jobless claims, among others) to fall considerably during the first quarter of 2023 thus giving rise to a bear market if history repeats itself.

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