What the yield curve signals


John Luke Tyner, fixed income analyst at Aptus Capital Advisors, discusses yield curve inversion with Bond Buyer Managing Editor Gary Siegel. Tyner looks at recession possibilities and how the Federal Reserve’s actions will impact the economy, the yield curve and recession. (23 minutes)

Gary Siegel: (00:03)

Hi, and welcome to another Bond Buyer podcast. I’m your host Bond Buyer Managing Editor, Gary Siegel. Today, we’re going to discuss the inversion of the yield curve. My guest is John Luke Tyner, fixed income analyst at Aptus capital advisors, John Luke. Welcome and thank you for joining us.

John Luke Tyner: (00:26)

Yeah, thank you, Gary. Appreciate the opportunity.

Gary Siegel: (00:29)

So there have been some brief inversions in the yield curve recently, and now the 2/10 is inverted. What exactly are you seeing in terms of inversion now and what do you expect in the near future?

John Luke Tyner: (00:44)

Yeah, no, it, it’s a great, great question and great starting point. I think that, you know we’ve seen the yield curve invert several times this year, but it’s just been for a day or two and then quickly reverted back to positive territory. But this time’s different. Since July 5th you’ve seen the curve invert and it’s, continued to stay pretty elevated as far as the inversion, hovering around 18 to 22 basis points or so. And I think it is concerning, it’s certainly, a part of the market pricing in some devastation, I guess, from the Fed’s activity in terms of aggressive rate hikes. And so you’re sort of seeing the front end of the yield curve remain elevated based off of the Fed tightening. And the long end is, in turn, falling based off of future growth. So it is something that we’ve really been paying it attention to. And the magnitude of this inversion, I think it is significant and should be catching investors’ eyes.

Gary Siegel: (01:43)

Let’s clarify for our listeners, what parts of the curve are the most telling in terms of recession. And when you talk about inversion in your recent answer, which part of the curve are you speaking of?

John Luke Tyner: (02:00)

Yeah, so, so we’ve seen the two year, 10 year treasury curve invert. We’ve seen that happen a few times this year, but that’s what I was referring to in the answer. But really what’s telling, I think to the Fed and to the market is the three month versus the 10 year treasury. And that has not inverted yet. And when you typically see the, the prelude to recessions, it’s the three month, 10 year inversion that’s been historically very accurate in predicting recessions. I will say though, that after next week’s, likely 75 basis point rate hike the three month and the 10 year will be inverted or darn close to inversion.

Gary Siegel: (02:43)

Well, we’re taping on July 22nd and the meeting is next week, but this won’t be posted after the meeting. So that’s a little bit of perspective for our listeners. Is there a certain length of time or, or amount of inversion that you’re looking at to predict a recession?

John Luke Tyner: (03:05)

This inversion between the, the two year and the ten year is one of the deeper ones that we’ve seen in, in modern history. Really we haven’t seen a depth of inversion like this, I think since the beginning of the 2000s. And so it certainly is significant and it doesn’t really seem to be receding. So I think that the longer that the curve stays inverted, the more concerning that it becomes for the economy and for the outlook. And, I don’t have a period of my expectation for how long it stays inverted, because I think there’s so many factors that play into that, namely, how, how soon out that the Fed cuts or pivots away from this aggressive tightening pathway that they’re in right now. Until that changes the front end of the curve’s going to stay mighty elevated in my opinion. And actually, if you look at the fed funds futures, and maybe I’m jumping ahead a little bit, but there there’s actually cuts that are projected for 2022, 2023 and 2024, about a hundred basis points. And those cuts, if those don’t happen, the front end of the curve would go even higher and the inversion would be even larger.

Gary Siegel: (04:19)

Right, that is the projection. After the numerous large increases the Fed is planning for this year, they’ve already made two, and they’re planning at least one more. The market believes that next year they will have to change path because the economy is slowing down. Are you seeing any red flags other than the yield curve?

John Luke Tyner: (04:46)

Yeah, I, I think, it’s so hard to look at economic data coming off of the 2020 time period and the pandemic with the policy response. It’s just not normal to see nominal GDP growth at near double digit levels and sort of maintaining there. And a lot of the economic data that we’re, that we’re seeing now is, is certainly slowing. You’re definitely seeing, the implications from the Fed’s tightening policy to have some negative implications for the economy, whether it’s housing, whether it’s PMI, and, and some of the other basic economic indicators are turning south. But I would say none of them are turning to a period or to a number that is devastating or just flashing the sign of like some sort of deep depression. You know, I think things are just normalizing as the Fed has been caught off guard with their policy. They obviously let inflation get too high. And the response has been in turn as aggressive as the lack of response last year. And so it’s the data I think, will continue to slow over the next several months as these hikes have sort of a lagging effect on the economy.

Gary Siegel: (06:09)

Yes. Monetary policy works with a lag, John Luke, and the Fed first raised rates earlier this year. So most of the tightening has not reached the economy yet.

John Luke Tyner: (06:25)

Right. Exactly. And, and if you think about it too, the more aggressive hikes have just happened right. The last two months. And so those will take some time to work their way through, but it’s hard to look at things and be awful bearish with the 3.6% unemployment rate. You typically don’t go into a recession with unemployment at that type of level.

Gary Siegel: (06:50)

Right. Which is one of the reasons people say that this is a very difficult economy to figure out. You’re very low on the unemployment rate, the economy until the beginning of this year seemed to be moving along quite well. And inflation is extremely high.

John Luke Tyner: (07:12)

Yeah. I think that when you look at the Fed’s mandates of low unemployment and stable prices, and then maybe also treasury liquidity, you know, they’re definitely at a good point from an unemployment perspective, you’ve got close to full employment if not full employment already. And, and the price stability piece is the main goal that they’re going to be fighting against for the foreseeable future. In my opinion, I think that the Fed’s going to have to likely hike rates into the end of the year and then hold them at higher levels to destroy some of the demand out there, because, you know, like chairman Powell said they can’t print oil, they can’t create supply or fix supply issues that we’re seeing. Andyou’re still seeing a pretty resilient consumer in a lot of the data.

Gary Siegel: (08:03)

Very true, John Luke. So is it just the results of Fed rate hikes and recession fears that are causing the yield curve inversion? Or is there something else at play here?

John Luke Tyner: (08:16)

Yeah, I think that a lot of the policy implications are certainly part or the main contributing factor to the curve version. You, you’ve certainly got a lot of factors that impact the front end of the yield curve. And that’s namely the Fed policy or the fed funds rate and the direction of that. And so that’s obviously keeping that elevated on the longer term part of the curve, namely the 10 year with these higher rate levels. You’ve probably seen some increase in demand from buyers now that there’s actually some yield back in the market. You know, although it’s, it’s still a ne negative real yield when compared to inflation. But I do think that after, you know, we went from 50 basis points on the 10 year in August of 2020 to, you know, we’re at 2.7, 8% today, but the high was around 3.50.

John Luke Tyner: (09:15)

That’s certainly enticing from a historical perspective for at least a modern historical perspective for investors to layer in. And I do think that you might, I do think that it’s likely that bonds or specifically treasury bonds will be a better insulator against risk moving forward than they have been the first part of this year. I mean, if you just look at like the TLT long term treasury bond ETF was down over 20% in the first half, that’s not supposed to happen when the S&P’s down, you know, 20% as well. So I do think moving forward from here, you’ve probably gotten some more retail participation and some more institutional participation in longer term treasuries, just considering the return, the future return outlook is better.

Gary Siegel: (10:03)

And how does inflation play on the retail picture?

John Luke Tyner: (10:07)

Yeah, I think that obviously consumers are worried about inflation, but from all of the expectation numbers that we’ve seen now versus three months ago or so they’re coming down. So I believe that the retail base believes that the Fed’s going to do what they need to do to get inflation back down to a more sustainable palatable level.

Gary Siegel: (10:31)

We need to take a short break and we’ll be right back to talk more about yield curve inversion. And we’re back with John Luke Tyner, fixed income analyst at Aptus Capital Advisors discussing yield curve inversion. So you’re not a big fan of the forward curve’s ability to predict the future. Why not?

John Luke Tyner: (10:56)

Well, I think if you just look back to how wrong that they were at the end of last year, where the forward curve was expecting one rate hike for ’22, and it’s been very slow to adjust upward, which, you know,it is sort of giving us a forward look or prediction of the future in terms of where policy goes and where yields are moving. So if you do disagree, it is giving you a tradeable opportunity, which I think is something to point out. But when you look at just the accuracy of the communication of the Fed, the past call it 18 months in terms of where inflation was going and in turn where the policy, where the fed funds rate and where the the monetary policy would have to go in turn it’s undershot dramatically.

John Luke Tyner: (11:49)

And so as far as where the forward curve’s ability to predict pricingit’s been awful wrong. And so, I do think that it is something to pay attention to because it is giving you where the consensus or where the market believes that rates are going, but it it’s just been awful wrong lately as far as its judgment of inflation and judgment of how the Fed would respond. And I think that you’ve seen a pretty massive shift here, call it the last three or four months where the market is now beginning to really believe that the Fed’s going to hike rates aggressively. And maybe even one of the more aggressive rate hike, regimes that we’ve ever seen.

Gary Siegel: (12:33)

Well, you talked about the past 18 months and since the beginning of the pandemic, the Fed originally thought that inflation would be transitory when it started again after the economy reopened. And there were a lot of economists on each side of it, some saying that inflation was gonna be transitory and others seeing problems. So it is quite difficult to predict the future, to say the least, and, you know, inflation fits into that category in the past 18 months. It was very difficult for some people to see it, whereas others were seeing it. Why was there that issue? Why were people so divided on that?

John Luke Tyner: (13:23)

Yeah. Well, I, I think your comment on the ability to predict the future that’s been absolutely correct. And in terms of the market, hasn’t done a really good job of predicting as a whole, at least.But I think, you know, the response that we saw from the pandemic from a fiscal and monetary perspective were just very unique to the times we haven’t really ever seen a time where the M2 money supply grew at 40% where we were sending checks to consumers where you had sort of a recession that happened where real incomes went higher and then supply chains also closed down. So I think that just the backdrop was sort of the perfect storm to get inflation. And you know, where this continues to go in the future is obviously a little bit up in the air, but, you know, again, the Fed can’t solve the supply issues that we’re facing. And until they’re able to curb demand, which it seems like it’s starting to happen, but I think it’s going take more action from, from the Fed to get there.

Gary Siegel: (14:32)

So getting back to the forward curve, what is it saying? How do you feel about that?

John Luke Tyner: (14:39)

Yeah, well sort of the comments a few minutes ago where the curve is projecting that the Fed will get to around 3.50, 3.40, 3.50, 3.60 in terms of the fed funds rates by the end of the year, and then quickly start to reverse policy back towards a more neutral rate. So if they hike to 3.50 or 3.60, that’s well above what the neutral rate that the Fed tells us of where the economy should be running at over the long term. And so that’s getting into a restrictive territory. So, I think that the hikes to get to that point are very likely. What I disagree with with the future curve is the cuts that are going to be imminent. You know, I think it’s going to take longer than the market thinks or anticipates in order to slow inflation down to a reasonable level. And so I don’t really trust that we’ll get those quick cuts as early as Q1 of 23.

Gary Siegel: (15:44)

So when would you think the cuts would come?

John Luke Tyner: (15:48)

Yeah, so I, I think what we’ll have to see is more destruction in the other two parts of the Fed’s mandate, whether it’s the jobs market really weakens from here, which, you know, you’re starting to see a little bit with like the continuing claims number rising slightly higher. And you’ve seen sort of that trending upward, but also the liquidity at the treasury market, you’ve sort of seen some of that come back in here the last few weeks whereit was getting a little bit concerning. If you look like at the move index, which sort of is the VIX call it, the VIX for the bond market for the treasury bond market was at like pandemic levels. It’s come in a lot lately here, the past, let’s call it two weeks, which I think the Fed’s probably pretty relieved to see. And so until we get more breakage and inflation, I think the Fed’s going to keep the pedal down.

Gary Siegel: (16:45)

Okay, let’s shift a bit and talk about GDP. Second quarter GDP comes out after we tape this John Luke, but before this podcast is posted. If the second quarter GDP is negative, that technically means we’re in a recession because we’ve had two quarters of negative growth. Some analysts have said that while we’d technically be in a recession, realistically we’re not going to be in a recession even if the second quarter GDP is negative. What are your views about a negative second quarter and what that would mean?

John Luke Tyner: (17:23)

Yeah, well, looking at, at the Atlanta Fed’s GDPNow forecast, they’re typically pretty accurate, and it’s still pointing to a negative second quarter, this close to the release of the data. So I do think that iit’s very likely that we’ll have two negative quarters in a row, which would fit the term of a recession. I know that there’s some flexibility as far as the classification from the National Bureau, the NBER, that deems whether we’re in a recession or not. But once again, it’s hard to say that we’re in a recession with unemployment at these levels. But if you look back to the ’70s and the ’80s, we actually had some recessions where both unemployment was low and, and the jobs market was actually gaining jobs similar to now, but also where nominal GDP was positive. And so we’ve just been, I guess, used to an environment where inflation has been so low, the last, you know, call it 20 years that any downtick in nominal GDP basically led to a recession, but this time I think that it is likely that we’ll see, you know, positive nominal GDP and a pretty strong jobs market. And we, we will actually be in a recession if you look at based off of the definition.

Gary Siegel: (18:55)

And the thing about the NBER is usually they look retrospectively. So they won’t say immediately that we’re in a recession, they’ll say months later that, yeah, that was a recession.

John Luke Tyner: (19:10)

Right. And I guess, you know, the hindsight note, it’s always easier to say after the fact. I it will be interesting to see how they classify this time, but, you know, we have had recessions in the past with the same type of data. But you know, when inflation is running at these levels, it’s pretty hard, for nominal GDP to outpace a 9% year-over-year inflation

Gary Siegel: (19:35)

Has the bond market priced in a recession?

John Luke Tyner: (19:38)

I think really the last few days, you’re starting to see it where the 10-year yield has drastically moved in, and obviously the inversion, he main topic of this recording is certainly a start to the prelude, or the prelude of what we would see going into a recession. And, you know, I do think that as we’ve seen, sort of, it’s been a little bit unique because you’ve seen the bond market act one way and the stock market act the other. But I think that the bond market in general is telling us that the times ahead probably aren’t gonna be as good as they have been. But I do think that the front end of the curve while it’s is elevated is overlooking the fact that the Fed’s going to be aggressive, regardless of if there’s some pain in the economy. And, you know, one more comment on that. I don’t think Chairman Powell wants to be looked back at as another Arthur Burns and letting the inflation of today create this spiral that was seen back in the ’70s and, and’80s. So I do think that it’s likely after the policy mistakes, that he’s already made, that if he makes another policy mistake, it’s likely to be being overly aggressive.

Gary Siegel: (21:00)

That’s interesting, John Luke, I can see that. Definitely. So what are your clients asking you about the economy, interest rates, the bond market, recession?

John Luke Tyner: (21:17)

Yeah, a lot of the questions that we’ve covered have come out from our clients, very similar to what we’ve discussed. I would say that there’s certainly some shell shock from clients with just how poor of performance that bonds have had in portfolios. It’s just not typical to see the Barclays Ag or TLT post the types of returns that we saw in the first half and, you know, act as a zero hedge to stocks, a negative first half in stocks. And I think that clients are definitely concerned about what the future outlook is from here. You know, as we saw a monumental rise in asset prices coming off the bottom of the pandemic probably escalated by some of the actions from a fiscal and monetary perspective, as we see those, those beneficiaries roll off and it impact risk assets negatively.

John Luke Tyner: (22:16)

I think clients are a little bit concerned about what the outlook is from here. But I do think when you look at a 20% down environment in stocks in a 10% down environment in bonds, you know, the one positive that we can point to is that future returns from here look a lot more attractive. And so, there is some negatives with the economy with what the inversion of yield curve is telling us with potential for earnings growth, to slow down from a very elevated pace. But in the end, we are getting back to levels that are projecting for higher future returns. So that is a positive,

Gary Siegel: (22:57)

Well, I want to thank you for your thoughts, John Luke.

John Luke Tyner: (23:00)

Thank you, Gary. It’s great to be on.

Gary Siegel: (23:02)

Thank you for listening to The Bond Buyer podcast. I produced this episode with audio production by Kevin Parise. Special thanks to my guest, John Luke Tyner, fixed income analyst at Aptis Capital Advisors. Rate us, review us and subscribe at bondbuyer.com/subscribe. from The Bond Buyer, I’m Gary Siegel. And thanks again for listening.

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