Inverted yield curves can warn of an economy losing momentum and heading toward a recession. The fear today remains that the Fed and other central banks have become too restrictive with their monetary policies resulting in the US economy slipping toward a recession (hard landing).
All eyes are on the FOMC meeting tomorrow. The expectation is another 25-basis point by the Fed to contain rising inflationary pressures.
Will this be the final Fed rate hike?
Does the recent extreme yield curve inversion imply an impending recession?
Under normal market conditions, the steepening of the treasury yield curve is a sign of an improving economy. It often translates to a bullish stock market outlook, strong corporate earnings, and under extreme conditions, an inflationary environment. The gradual rise in interest rates and the steepening of the yield curve have bullish implications. It suggests the market expects a sustainable economic recovery. However, sharply higher yields and an extremely steep yield curve can signal the economy is expanding too fast, leading to inflation which forces the Fed to hike interest rates to cool an overheated economy.
Studies show the 3-month treasury yield is a reliable proxy for the short-end of US maturities. The 10-year yield remains the benchmark for long-term US interest rates. The sharp and abrupt yield curve inversion from May 2022 (2.27 high) to Jan/Mar 2023 (-1.32/-1.34) is discerning for many investors as the spread has fallen significantly below the Jan 2001 record low (-0.95).
Under extreme market conditions, a steep and prolonged sharp expansion in the yield curve can also lead to hyperinflation. When the economy overheats as inflation pressure rises, this is negative for stocks as corporate earnings and profit margins come under pressure.
Typically, the yield curve does not often steepen, with the long-end rates moving up far above the short-end rates. However, when this occurred, it led to a difficult period for the financial markets.
Why? When long-end rates rise too rapidly, the Fed becomes increasingly concerned about rising inflation. The FED will then move to cool an overheated economy by raising rates to prevent inflation from running away. The objective is to slow down the economy and create a soft landing. A policy mistake may also lead to a stock market correction or a bear market decline. The Fed must be careful – an overly restrictive policy can trigger a hard landing.
The pertinent question remains - when does the stock market begin to price in too high of an interest-rate environment? A lot depends on the extent and the duration of the FED interest rate hikes. Most importantly, how steep the yield curve becomes.
Our technical studies show the normal steepening of the US yield curve is positive for the economy and the stock market. However, too sharp of a rise in the long-term interest rates can steepen the yield curve to an extreme level which causes problems for the FED, the economy, and the financial markets.
In prior technical reports and blogs, we have mentioned the inversion of the US Treasury yield curve does not necessarily lead to an economic contraction or a major US recession. When the spreads between the 10-year yields and the 3-month yields contract to an extreme low (negative) and suddenly reverse direction in a steep and sharp acceleration, this triggers an economic contraction or a recession.
The stock market is a leading indicator of US business cycles. And, in turn, interest rates tend to lead stocks. The stock market will often peak well ahead of the economic top. The stock market will also bottom ahead of the economic trough. Interest rates (yields) also lead, turning higher or lower ahead of changes in business and stock market cycles.
The prior US yield curve expansions and contractions are summarized below.
Tech/Telecom Dot.com bubble – The yield curve traded to an extreme low of -0.95 on January 2000. It would soon reverse its direction and expand higher. The steepening of the yield curve subsequently led to the Tech/telecom dot.com bubble burst and the ensuing 2000-2002 stock market bear market.
Global Financial Crisis – Once again, just before the onset of the global financial crisis, the yield curve spread contracted to an extreme low of -0.64 in February 2007 before suddenly reversing direction and expanding sharply higher. It will also trigger the 2007-2009 stock market bear market.
Covid-19 Pandemic/recession – US yield curve again plummeted to an extreme low of -0.52% in August 2019 before rebounding near the pivotal 2007 bottom (-0.64 spread). The yield curve bottoms and widen.
In Sept 2020, the yield curve spread cleared above two major long-term moving averages, the 10-mo and 30-mo ma (currently at -0.25 and 0.85), and in the process, confirmed a monthly golden cross-buy signal. The technical development further led to the steepening of the yield curve. The breakout above the 2014 downtrend (0.92-0.93) and a higher-high pattern above 1.16 (March 2020 reaction high) further reaffirm a bottom and signal the steepening of the yield curve.
The rally suddenly stalled at 2.27 (May 2022) or near key resistance at 2.09-2.48(Jun 2015/Dec 2016 highs). A negative outside month (May 2022), a large gap down (Jul 2022), violation of the 10-mo/3-mo ma (Jun/Jul 2022), and a death cross-sell signal (Oct 2022) warn of a sharp contraction. In the months before spread inverted sharply lower, breaking its Aug 2019 low (-0.52), Feb 2007 low (-0.64), and Jan 2001 all-time low (-0.95).
A potential positive outside month has developed in Mar 2023 (-1.34 low). If confirmed by the end of the month this hints at the bottom and the start of the next spread expansion.
In summary, three prior occurrences of steepening of the yield curves, two led to extreme steepening, resulting in recessions and SPX bear declines (i.e., 2000-2002 and 2007-2009). However, a third occurrence (2013-2014) resulted in a modest widening of the yield curve, neither triggering a recession nor an SPX bear decline. Will we repeat the former or the latter?
