Treasury Curve Un-inverts, Good News or Bad News?

The U.S. dollar against the background of a declining chart. (Shutterstock)

Commentary

What “should” have happened last month to the Treasury curve did not. The Federal Reserve, as you know, is in a race with itself to fulfill what are almost certainly politically-driven directives. From the White House through the Halls of Congress, the need for someone somewhere to appear to be doing something about “inflation.”

Since that job is, by law, for the Fed what we’re getting is rate hikes. The FOMC, the central bank’s policymaking body, voted last month for a single quarter-point increase to its federal funds range. More increases are on the way, likely to be at double the change.

That’s not all. Having increased its own balance sheet after more than two years of exceptionally large asset purchases, known colloquially as quantitative easing, the FOMC already stopped its increase and now intends to begin decreasing perhaps as early as next month.

Just how these moves might arrest the accelerating CPI is actually anyone’s guess. There is no science here; on the contrary, not only is the Federal Reserve being forced to act politically, there is not now, nor has there been, any correlation whatsoever between its policies and consumer prices (let alone conditions in the wider economy).

For one thing, nothing the FOMC will do today or tomorrow is going to get more oil up from out of the ground; either here in the United States or from anywhere else around the world.

Gasoline prices, in particular, are the forefront of what the public considers to be inflationary excesses when the actual economic case is one of a non-monetary supply shock. There are, therefore, two ways to end the price pain.

The first is greater supply; basic economics. The second is an old expression: the solution to high prices is … high prices.

Eventually, paying more and getting less leads to all manner of big economic problems where consumers just stop buying; and not only what goods or services have become relatively more expensive. This scenario of what’s called demand destruction isn’t theory, nor is it some far distant worry.

It is visible right now all around the world, from Europe to China and all those multitudes of the world’s people in between. The supply shock spiking oil and other goods prices is not an American problem alone (a key clue how the Fed isn’t really involved here).

Since suppliers and producers aren’t willing or able to fill demand in oil, and, outside of energy, manufacturers can’t produce then ship whatever goods in the same nimble, efficient fashion as they once had, Fed rate hikes won’t solve any of these imbalances leaving everything up to the basic economic forces of something like recessionary demand destruction.

However, the FOMC’s intentions do have one direct impact, and that’s on the Treasury yield curve. Anticipating these rate hikes, yields at the front end of the curve have gone higher; much higher. Those at the far end of the curve, longer-dated notes and bonds, they’ve gone up, too, but not nearly as much (above).

The yield curve has therefore flattened dramatically.

A flat yield curve is one where the spreads or differences in yields between those longer-dated Treasuries and others of shorter maturities diminish. Smaller calendar spreads like these indicate concern and a higher perceived (by the market) potential for future economic and financial trouble; a growing appetite in this huge, sophisticated market to hedge (in various ways) against a more likely and more widely-accepted risky scenario(s).

Since bond yields started out so low, being near-zero after 2020’s unwise and unnecessary recession, what should have happened as the Fed in 2021 began to signal rate hikes for 2022 was only a modest flattening of the yield curve rather than its literal depression down to nothing which began last October (above).

Continuing on, eventually the curve inverted (that is, longer-dated Treasuries yielded less than those of shorter maturities, completely upending what’s typically normal and healthy in the upward slope of the curve). What most of the public knows is that yield inversion, particularly the spread between the 2-year and 10-year, is historically associated with recession.

Since April 1, however, the yield curve is, mostly, un-inverted again. Longer-run spreads are back above their shorter counterparts currently. Recession risk canceled?

Had the curve done what it was supposed to have done originally, then, more likely, yes. What we’re seeing now, however, is actually the “bad” steepening associated with potentially an economic contraction closer at hand than anyone is expecting, or by historical account.

In other words, the yield curve always steepens after inversion; if that steepening happens to be because yields at its front are falling more and faster than yields in back, this is the “bad” form.

You can find this “bad” kind of steepening more immediately preceding any recession case. In the months prior to the 2007–2009 Great “Recession,” the inverted yield curve from 2006 had already begun to shift in that direction (late February) even before former Chairman Ben Bernanke had uttered his now infamous “problems in the subprime market seems likely to be contained” blunder at the end of March.

In the year 2000, just prior to what became 2001’s dot-com recession, back-end inversion had arisen in late 1999, deepened in January 2000, and then “bad” steepening shortly thereafter which would continue throughout the rest of that year even though the FOMC at the time under Alan Greenspan would continue to hike rates until mid-May!

Those at the Fed never pay the curve any heed; not then, not now.

What all this means is relatively simple; inversion isn’t the “thing” to worry about, rather it’s when inversion disappears if only to get replaced by the bad form of steepening (the “good” form would be if longer yields continue to rise and do so more than shorter yields, each keeps going along with the FOMC’s projections into the future; I should point out, this never happens which is why whenever inversion shows up even the public knows to look out).

It is way too soon to make any conclusive determination about the current yield curve signal even now as it has un-inverted the wrong way. This could turn out to be nothing more than a temporary market fluctuation, another common occurrence associated with inversion periods. As you can see on the charts above, oftentimes the curve will invert, un-invert, re-invert several times before the “bad” steepening ultimately takes over right before.

But that’s the point; whenever it finally does, then you’ll know the contraction is on its way. As of right now, this could be the case, though much more confirmation is needed. Either way, the curve and the market continue to look upon rate hikes and everything else Fed-related as nothing more than unhelpful, irrelevant theater.

The end of our “inflation” still projects to be very different from the politics.