A primer on yield curve inversions.
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Thread.
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History says that yield curve inversions lead us into recessions.
The chart below is pretty telling: going back 50 years the track record is pretty much intact.
But why?
What are the exact mechanics at play here?
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The chart below is pretty telling: going back 50 years the track record is pretty much intact.
But why?
What are the exact mechanics at play here?
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Spotting empirical market behavior is a common trait of good investors, but the best macro minds out there can go a step further: they can deeply understand the very mechanics behind market behaviors.
So let's try to understand why curve inversions lead us into recessions.
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So let's try to understand why curve inversions lead us into recessions.
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Step 1: The Fed starts hiking rates fast.
2-year yields immediately move higher as they reflect the new Fed stance and future hikes that are coming.
Longer down the curve, the story is different...
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2-year yields immediately move higher as they reflect the new Fed stance and future hikes that are coming.
Longer down the curve, the story is different...
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...as 10-year interest rates are driven by growth and inflation expectations (+ term premium).
There, investors start extrapolating that all these hikes will hurt future growth and inflation: 10-year yields move higher but much more slowly.
The curve inverts.
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There, investors start extrapolating that all these hikes will hurt future growth and inflation: 10-year yields move higher but much more slowly.
The curve inverts.
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Step 2. The Fed stays the course with their hiking cycle
Even if growth starts slowing down the Fed won't bail in as they must bring inflation back to 2%: more hikes come in, and as investors face a weaker economy the curve inverts even further.
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Even if growth starts slowing down the Fed won't bail in as they must bring inflation back to 2%: more hikes come in, and as investors face a weaker economy the curve inverts even further.
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Step 3. Companies and households are under pressure
The usual macro lags last between 10-27 months: that's how long it takes for the initial curve inversion to feed into actual pain for the private sector.
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The usual macro lags last between 10-27 months: that's how long it takes for the initial curve inversion to feed into actual pain for the private sector.
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The longer credit conditions are tight while the economy slows down, the more companies and households will be forced to refinance at prohibitive conditions right when their earnings stream are dwindling.
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Step 4. Cut costs and investments
Forced to allocate a larger portion of their budget (salary, earnings etc) into higher debt servicing bills, households start spending less and companies are forced to cut labor.
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Forced to allocate a larger portion of their budget (salary, earnings etc) into higher debt servicing bills, households start spending less and companies are forced to cut labor.
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Now a vicious loop unfolds: less jobs, less spending, less earnings, less jobs...
Step 5 is here: Recession
There you go: now the mechanics by which an initial yield curve inversion leads (with variable time lags) into a recession should be clear.
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Step 5 is here: Recession
There you go: now the mechanics by which an initial yield curve inversion leads (with variable time lags) into a recession should be clear.
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Understanding how bond markets work is a crucial skill to become a better macro investor.
That's why I am soon releasing an educational bond market piece.
But you'll only get that if you subscribe to my newsletter.
It's FREE
πππ
freetmc.ck.page
11/11
That's why I am soon releasing an educational bond market piece.
But you'll only get that if you subscribe to my newsletter.
It's FREE
πππ
freetmc.ck.page
11/11
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