Yield Curve Inversion Occurs - But Is Anyone Paying Attention?

Fed chief Jerome Powell and yield curve for March 25, 2019 (from T. Rowe Price Investor Bulletin, December, 2018)

For some time now, over the past 4 months, I've warned of potential yield curve inversion and how it's often signaled recession or massive downturn  I noted recessions tend to occur once the "flat" yield curve becomes "inverted" - with short term (e.g. 2 -year)  bond rates higher than long term (e.g. 10 year) rates. As a recent T. Rowe Price Investor Bulletin warned (p. 4) this condition has transpired before each of the past nine recessions dating back to 1955.  Hence, while it isn't a 100% absolute predictor, it is a significant historical marker..

The T. Rowe warning - assuming one can take it as such - is (ibid.):

"The yield curve is not flat yet ...but it could be by next March if the Fed maintains its 0.25 percent per quarter pace of rate hikes and the 10-year Treasury continues to meet resistance above the 3.0 percent level.  Starting the historical average 16-month clock from the spring of 2019 would raise the specter of a major downturn by 2020."


Interestingly, last Thursday we learned (WSJ, 'Treasury Yields Tumble After Fed Restraint', p. B12)  that "the yield on the two year Treasury notesettled at 2.402% on the day before compared with 2.471 % Tuesday. This marked the biggest one day slide since the start of the year, according to Dow Jones Market data."

 Given what happened March 21st, it shouldn't have been totally surprising the yield curve might actually have inverted on Friday - March 22nd - which it did.   One of my favorite go-to financial forecast sources, James Mackintosh in the Wall Street Journal wrote:   

"The market’s most reliable recession indicator is finally flashing red. With the Treasury yield curve inverting on Friday—the 10-year yield fell sharply to be lower than the three-month for the first time since 2007—is it finally time to prepare for an economic downturn?”

Good question! I believe so, as I've written before given I suspect the correlations over time (see graphic are almost as reliable as sunspot activity curves in predicting large flares.   It is therefore of interest to inspect the yield curve for March 25th, with Treasury bills designated along the abscissa, e.g. with bond terms from less than five years to 30.  Note also the curve behavior and how it changes with the specific bonds.


Look carefully and you will see the evidence for yield curve inversion, rates, hence the freak out for may. Subsequently economist and NY Times columnist Paul Krugman wrote the following in a tweet:


Mackintosh, for his part, has always been somewhat agnostic on the value of the yield curve as forecaster of recession. He writes, for example:

The yield curve might be less reliable than its recent U.S. history suggests. It has a terrible record internationally, for instance. It flat-out hasn’t worked in Japan, also has a poor record in the U.K. and in Germany provided no advance warning of the 2008 recession, the worst since reunification. At the moment the curve isn’t inverted in any of them thanks to superlow or negative interest rates, even though all are struggling with greater economic troubles than the U.S.


In other words, one needs to bring to bear skepticism as to the historical evidence.

But then in subsequent text  we behold some very crucial points:

“Previous inversions took place at much higher short rates — 5 or 6 percent, versus 2.5 percent now.”

He continued: “So this inversion actually reflects a worse outlook for the economy than the number itself suggests. Again, it’s not a direct read on the economy; it’s a read on what the average bond investor thinks is happening to the economy. But still not encouraging.”

We should also bear in mind what Mackintosh wrote back on July 3, 2017, as regards the assumption that bear markets only come with recessions, i.e.:

"Investors believe that bear markets only come with recessions, and so reassure themselves that there is no sign a recession is imminent, repeating the mantra that 'economic cycles don't die of old age'. Unfortunately, this is both wrong and useless.

First, 20 percent drops happen outside recessions, as in 1987 and 1966. Second, economic cycles can be killed by a financial crash, and as the late Hyman Minsky pointed out, the longer a financial cycle goes on, the more likely it is to turn to excess and end badly. Worse, there is no reliable method of forecasting a recession, so even if it were true that only a recession can end a bull market, that isn't a lot of use to investors."

Put aside yield curve inversion, as yields fell and the curve merely flattened, "investors punished bank stocks ... A flatter yield curve hurts banks stocks because it narrows the gap between what lenders pay on deposits and lend on loans- a spread known as the net interest margin."  (WSJ, Mar. 22,  p. B10 ).  What especially bothered me even earlier (than seeing the yield curve inversion) was reading WSJ columnist Greg Ip's March 21  warning piece:

The Fed's New 'Normal' Looks Worrisome - WSJ

https://www.wsj.com › Economy › U.S. Economy

And how we needed to be wary of the Fed's sudden dovish inclination. Quoting Mr. Ip, which I believe is important to get the context:

"The Federal Reserve now believes its monetary policy is back to normal. That should worry you.  If this is normal then the Fed has precious little ammunition for when economic conditions again turn abnormal."

Ip then goes on to note that since 2005 the Fed had been 'normalizing' monetary policy by raising interest rates and shrinking its bond holdings."  (From the quantitative easing or QE policy.)

But:   "This week it declared the process all but done"  Adding to this,  the Fed big wigs see "no more rate increases this year"  and "they will stop shrinking the balance sheet".   This is nothing short of mind boggling, given almost $4 trillion of toxic bond assets remains on its balance sheets.   Even by September the bond balance will only be down to $3.5 trillion or 17 % of GDP.

Also, ceasing to increase interest rates puts the screws to millions of senior savers - who'd been saddled with pathetic low rates for over a decade. As one of the few segments of the ordinary citizen financial demographic with money to spend, this is not a sound move.   Ip also warns  (ibid., this is all from the original print version, not the digital update):

"Should the economy stumble again, the Fed won't have much ammunition with which to respond."

Well, unless it resorts to the "negative interest rate'"  route which the Swiss also attempted with adverse results, and millions actually stuffing money (cash) under their mattresses. I mean, who the hell wants to keep it in the bank and lose $$?

But perhaps there is method to the Fed's madness. As James Piereson writes ('How Debt Makes The Markets Volatile',  Feb. 28, p. A17):  "Stocks are becoming more sensitive to interest rate hikes because the global economy is over-leveraged."

Something I've also addressed before, in conjunction with IMF warnings and : 

"Vitor Gaspar, the director of fiscal affairs at the  IMF, singled out the U.S. for criticism, saying that it was the only advanced country that was not planning to reduce its debt pile - with the recent tax cuts keeping public borrowing high.  

The fund urged policymakers to stop 'providing unnecessary stimulus when economic activity is already pacing up' and called on the U.S. to 'recalibrate' its fiscal policy and increase taxes to start cutting its debt." 

So no, the GOP-Trump tax cuts - which effects are driving millions crazy now in terms of low or  no tax refunds -  did not help the situation. Assorted experts have estimated $1.5- 2 trillion in added deficits. And as the WSJ's Gerald Seib put it (Feb. 19, p. A4): "As the accumulated debt rises, the bill to pay the interest on the debt rises too."   See e.g.

Brane Space: IMF Debt Warning Ought To Send Chills Through Every ...

brane-space.blogspot.com/2018/04/imf-debt-warning-ought-to-send-chills.html

As 

Why January's "Best Stock Performance in 30 Years" Is A Mirage

The WSJ font page article Friday ('Stocks Post Best January In 30 Years'.)  babbled shamelessly:

"Banks and smaller companies propelled stocks to their best January in 30 years, a sign investors are favoring sectors tied to the U.S. economy....The Fed's statement Wednesday that interest rate increases are on hold helped ease investors' worries that higher rates would lead to higher borrowing costs and curtail corporate profits."

Well, of course the Federal Reserve's statement would do that, given - god forbid - it doesn't want to halt the cheap money bandwagon. Or, for that matter, toss cold water on the manic leverage that now dominates stock purchases as well as corporate expansions.  It seems every  manjack now wants to go into debt to achieve a gain - and of course at the hoi polloi's expense.  Because they are the ones that will have to do the bailing out. (Think of the AIG bailout in 2008, and Long Term Capital Management before that.)

Off the financial media's radar is the other part of the cheap money equation: quantitative easing ("QE") which has undergone several iterations since the credit crisis.  Most ordinary people are not even aware of the amount, the magnitude - of the crutches the Fed has provided to prop up the markets. Most  investors, ignorant though they may be,  have been beneficiaries of the Fed's infusion of "crack" in the form of  QE  cheap money "crack".  Notice especially how the DOW stopped dropping once the buzz began about QE3  (following QE1 and QE2)   - back in 2012- which have together infused $4.3 TRILLION in bond purchases.

But at some point, the cheap money flow has to stop and we know even if it's done slowly Maul Street will respond hysterically. This  is what has prompted discussion of how large a future correction will be   But let's get back to the Journal's blabber - woky of the greatest January in 30 tears. We agree the Fed deciding not to raise interest rates is part of it - but the other part ("that which must not be mentioned") is the quantitative easing - and rolling it back to get the Street off its addiction.

Flash now to an article on the same day (p. B12,  Heard on the Street, 'The Fed's Balance Sheet Needs Taming')  whereupon we learned:

"The famously plain-spoken Mr. Powell  left the market with little doubt that the probability of tightening has shifted, noting on Wednesday that the 'case for raising rates has weakened'.  But policy rates are only part of the story.

Since the financial crisis the Fed has used its balance sheet as a powerful tool, buying bonds to affect the yield curve. Since late 2016, it had begun to slowly unwind those purchases, most recently at a pace of $50 billion a month.  The Fed's balance sheet has shrunk by only 10 percent."

Okay, let's do the math: if the original balance was $4.3 trillion and the QE balance sheet has shrunk by only ten percent - according to the WSJ - then than means only about $430b  has been removed.  That leaves $3.87 trillion still to be unwound.  Now, at the rate of $50 b a month how long will it take to remove all that excess crack?

Again, we can do the math:   

Y   =   $387 trillion/  ($50 b x 12) = 6.45 years

And that only holds up if we don't get yet another recession.

And this may well be lowballed because "the actual amounts have been closer to $40 billion in recent months" (WSJ, January 29, ibid.).

How is this unwinding happening?  Well, by allowing the purchased Treasury and mortgage securities to mature without replacing them.  But even this tortoise -paced process has some prominent investors rattled, such as Stanley Druckenmiller who claims it's "a big factor behind the return of market volatility".  ('Fed: Stock Swings Not Tied To Bond Moves', p. A2, WSJ, January 29).

Now, let's back up and process what the yield curve means and how the Fed's QE policy is affecting it and how it could lead to a new recession. As noted in my post of December 5th: the U.S. Treasury yield curve is the spread between the 2- and 10-year Treasury bond yields.  It is taken to be a predictor for recession especially if it becomes "inverted".  (See e.g. 'Fear Of Inverted Yield Curve Stalks Markets', Jan. 10, p. A2)

Prior to that inversion, it becomes "flattened" in other words, the difference between the 2 and 10 year bond yields is minimized.  Specifically, recessions tend to occur once the "flat" yield curve becomes "inverted" - with short term (e.g. 2 -year)  bond rates now higher than long term (e.g. 10 year) rates. As a recent (December, 2018) T. Rowe Price Investor Bulletin noted (p. 4)

"The yield curve is not flat yet ...but it could be by next March if the Fed maintains its 0.25 percent per quarter pace of rate hikes and the 10-year Treasury continues to meet resistance above the 3.0 percent level.  Starting the historical average 16-month clock from the spring of 2019 would raise the specter of a major downturn by 2020."

But ok, you say, the Fed is no longer going to increase interest  rates, so we dodged a bullet. Not so fast.  There's still that huge balance sheet. To make this clearer let's understand that the QE balances are really an alternative to printing more money. (Which we understood used to be done in the old days, or more recently by the last government of Barbados to try to pay all its obligations.) 

According to one technical financial paper

Monetary easing is the Fed’s way of putting in more money into circulation in the economy....and it does not involve the printing of new banknotes

True, but still it effects the yield curve. How?   According to the same Market Research paper:

The Fed’s QE initiatives have successfully shifted the yield curve downward, that is, lowered the Treasury yields across maturities.

In other words, shifted down as in flattened the yield curve.  More worrisome - from the earlier cited WSJ article on the Fed's balance sheet needing taming:

"Moreover, he (Powell) raised the possibility that the balance sheet  could be an 'active tool' if warranted. In other words more bond purchases if markets or the economy cry out for more help."

In other words, merely postponing the 'big one' while other recessionary signs build - and the "insurance" of QE itself becomes a ticking time bomb.

What are those other recessionary pressures?  From a separate WSJ article ('Chances of Recession are Rising') they include:

-  Another shutdown following the one for over 4 weeks which sapped GDP at the rate of 0.1 % per week.    That initial "partial" shutdown already hurt "sentiment measures:  - but these ought to rebound provided there are no further shutdowns.  But given the bombastic fool holding office, who can say? We know he will likely try to make another specious case for his ignorant 'wall' tomorrow night. Another reason not to waste one's gray matter or time tuning in to Dotard's lies, bragging and  babble.

- "The tight labor market is another reason the recession chances have risen" i.e. in models including from JP Morgan.    Most economists in addition believe the current rate is unsustainable.

A further cautionary take has been offered by James Mackintosh (WSJ, Jan. 30, p. B1) who notes there is clear evidence the Phillips curve (the statistical link between inflation and unemployment has "broken down".  Mackintosh adds:

"If the relationship is finished economists will need to build new models of how the economy works.  Investors should applaud such a change if it shows that higher wages tempt people back into the workforce.  That would demonstrate more spare capacity than thought, so the economy could grow without sparking inflation"  -  and presumably inciting a Fed reaction like more QE!

Where the biggest risk lies is perhaps in a confluence of factors. That is, the Fed is reducing its bond portfolio at the same time the Treasury is issuing more bonds to fund large federal budget deficits - crowding out capital for other types of investment. This is the same type of risk I forecast after the Trump - GOP tax cuts were implemented.  Basically, a systemic instability triggered by unnecessary deficits from a stimulus not needed when the economy was already humming - thanks to Obama's wise moves in holding deficit spending down. (As finance specialist Steve Rattner  aptly pointed out this a.m. on 'Morning Joe')

Watch for what transpires in the next two weeks and whether Dotard calls for another shutdown. If he does, and renews his temper tantrum, the probability  of a recession increase to more than 90 percent. Especially as over 4 million federal  contractors are still trying to financially recover from the last debacle!

2019 Forecasts: Climate Change Becomes Unstoppable; Trump Is Impeached, Indicted, Resigns

Forecasting future events is always a dicey proposition but I feel fairly confident regarding those predictions I make below for 2019.  Let me say only one thing here: those of us facing this new year had better buckle our safety belts as it will be even more tumultuous than 2018.   So, without further ado, let's proceed:

1) Climate Change Becomes Unstoppable.

One item that we need to get clear concerns the threshold for climate change becoming "unstoppable".  This is not, as many suppose, that the putative CO2 concentration limit is reached, estimated at 600 ppm by Prof. Gunter Weller, formerly of the Geophysical Institute in Fairbanks, AK.   The reason is that climate change acceleration is not based merely on release of CO2, but also  on another much more powerful greenhouse gas, methane.

For specific reference, a 2017  study of permafrost found that the ice wedges forming the prevalent honeycomb pattern across the tundra appear to be melting rapidly across the Arctic, changing the hydrology of the region and accelerating the release of  methane with major implications for global warming. As I noted in previous posts, the main gas released with melting  permafrost is methane, which traps 25 times more atmospheric heat than carbon dioxide does on a 100-year timescale. Hence, any significantly increased release of methane is serious cause for concern.

While the gradual warming of permafrost has been well documented in the Arctic, this  study published in  Nature Geoscience indicates that a brief period of unusual warmth can cause a rapid shift. Focusing on the polygon ice troughs associated with wedges of ice that thrust deeply into the ground, the study found the ice wedges are quickly melting, amplifying the loss of permafrost by altering the storage and movement of water.   According to Cathy Wilson, a geomorphologist with Los Alamos National Laboratory (Earth and Environmental Sciences Division), who coauthored the paper:

“The unique structure of ice wedge polygon landscapes promotes ponding of water and the accumulation of vast stores of soil carbon as wetland vegetation dies off seasonally and is buried and frozen over thousands of years, When ice wedges melt, the land surface collapses to form ‘thermokarsts’—lands dominated by irregular marshy hollows and small hummocks. These thermokarsts dramatically change hydrology by either creating a lot of new ponds, which absorb heat and increase thawing of the tundra, or draining and drying polygon ponds by connecting them into a continuous drainage network.”

Permafrost is hundreds of meters deep in many places and has been frozen for millennia.  It covers nearly 24 percent of the Arctic and stores nearly 1,700 gigatons of organic carbon, far greater than the amount of carbon already in the atmosphere. Permafrost has been thawing in recent decades and releasing greenhouse gases.

Satellite image of permafrost melting near Liverpool Bay, Canada


My forecast here is based on the more rapid release of permafrost, combined with the failure to take critical  CO2 feedback mechanisms into account,  as noted by The Bulletin of the Atomic Scientists,  e.g.

Climate report understates threat

Excerpt:

"So far, average temperatures have risen by one degree Celsius. Adding 50 percent more warming to reach 1.5 degrees won’t simply increase impacts by the same percentage—bad as that would be. Instead, it risks setting up feedbacks that could fall like dangerous dominoes, fundamentally destabilizing the planet. This is analyzed in a recent study showing that the window to prevent runaway climate change and a “hot house” super-heated planet is closing much faster than previously understood."

 These in conjunction with Trump's EPA now punting on the climate change mission,   e.g.

http://brane-space.blogspot.com/2018/09/cat-6-hurricanes-searing-heat-and.html


leads me to believe time has run out. It will run out this year in terms of the latitude for options to stymie or slow climate change, making its onset unstoppable.  In effect, whatever few pathetic policies humans make will be too little and too late.  As if the teragrams of methane released by melting permafrost weren't enough, we will now also  have to contend with additional teragrams released by additional methane burn off - owing to a decision by Trump's EPA. 

In this context it is also important to process the limitations of trying to "adapt" as some popeyed purveyors of  Climate change Pollyannism have pushed. The reason - evident to anyone who's taken a college (or even high school) biology course - is that the human body can't tolerate excessive heat.  The biological and chemical processes that keep us alive are set to a narrow band of 96.8 to 98. 6F.   Beyond that, the human body's response to excess heat is to try to get rid of it. The problem is that as the warming of the planet reaches critical levels this will be all but impossible as cooling becomes impossible. Ask the people of Puerto Rico after Hurricane Maria took out their power grid.  Now, consider the demand on our continental U.S. grids reaching enormous proportions as we see heatwaves lasting weeks or months.  The sad fact, the available power supply will be too little to meet demand.

2) Trump Is Impeached, Indicted, Then Resigns

Readers here may wish to recall  that Michael Cohen's perjury didn't end with his lies and omissions to the SDNY.  Indeed,   Cohen previously pleaded guilty to lying to Congress about Trump’s plans to develop a building in Russia. He admitted the project continued well into Trump’s campaign for the presidency – contradicting Trump’s account – and that Cohen spoke with a Kremlin official about securing Russian government support.


In other words, we have direct evidence of a devious and nefarious synergy between Trump and the Russkies,  that permeated the Trump campaign.  Let's clear the air here and state emphatically that Trump is guilty of at least two felonies and hence two impeachable offenses.   This take is resoundingly confirmed by Neal Katyal former Acting Solicitor General in the Obama Justice Dept. see e.g.

https://www.msnbc.com/all-in/watch/neal-katyal-this-is-the-beginning-of-the-end-for-trump-1384324675700 

He noted even if the Dems don't want to look at impeachment they are going to have to, they  can't simply ignore it. Trump's transgressions are now a matter of "national security".  By the time of Mueller's probe conclusion the only out for Trump will be resignation, or face indictment - also noted by Katyal in a followup appearance on All In. 

As MSNBC's  Lawrence O'Donnell  made clear to soon-to-be  House Judiciary chair Jerry Nadler 3 weeks ago,  any failure to impeach Trump  - even if it doesn't lead to indictment (by the Senate) -means that Trump and any followers will believe he's above the law. (Jerry kept telling Lawrence the Dems "need at least twenty Republicans" - but that is only for indictment in the Senate, not impeachment.)   My take is the dominoes will fall rapidly once the details of Mueller's probe are known. (Though there is talk by some pundits that whoever the Trump appointed AG is, he will act to censor the release. But that remains to be seen, and personally if that cynical tactic is used the blowback will be serious.) 

  Meantime, little Holman Jenkins continues to pander to fellow FOX News followers with balderdash (WSJ today,  'Mueller's Report Will Be A Bore', p. A13) about Mueller "concocting a confection of guilt by innuendo based on the Russia related dealings of Mr. Trump and the people around him."    Well, don't stake your yellow journalist rep on that twaddle, sonny!

3) Polarization and Incivility Increase Owing to Split Media:

At the same time Trump is driven out of office, likely by October or November,  there will be major backlash and civic unrest as the Trumpie base goes insane because "Libruls' have repealed the 2016 election result."    This will be a direct result of these goofballs getting all their "news"  - actually conspiracy bollocks and misinformation - from FOX News. 

I  have posted on the bifurcation of news- information sources for some time, warning it creates two distinct national perspectives  and no nation can last for long if it contains two populations accepting widely divergent realities. I have also singled out FOX News as the biggest culprit in gutting the febrile and already gullible brains of a segment of the populace,  dividing our nation more with each passing month.   This division will reach its greatest chasm after Trump is forced to resign - or face prison time- and the reaction will lead to major unrest across the nation.   Let's put it this way:  The Trumpies will not take the ouster of their criminal leader and chief pussy grabber lightly! 

4) Recession By The End Of The Year.

As I noted in previous posts on the issue, the U.S. Treasury yield curve - the spread between 2- and 10-year Treasury bond yields- has flattened sharply this year,  e.g.

Yield curve behavior since 1977  (from T. Rowe Price December Investor Bulletin)

But has not yet "inverted" - which most investors take as a sign of a looming recession. Specifically, recessions tend to occur once the "flat" yield curve becomes "inverted" - with short term (e.g. 2 -year)  bond rates higher than long term (e.g. 10 year) rates. As a recent T. Rowe Price Investor Bulletin notes (p. 4) this condition has transpired before each of the past nine recessions dating back to 1955.  Hence, while it isn't a 100% absolute predictor, it is a significant historical marker.  But by November  (or possibly earlier - depending on how soon Trump is ousted)  the inversion will be well underway, and the fallout from the continued trade war with China and attacks on the Fed will have taken a massive toll.

The T. Rowe Price Investor Bulletin warning is clear (ibid.):

"Starting the historical average 16-month clock from the spring of 2019 would raise the specter of a major downturn by 2020." 

Interestingly, this take also conforms with the one 2 weeks ago by  Matt O'Brien writing in the WaPo ('Reasons There Really  Might Be A Recession In 2020').    O'Brien tags the "two big risks" today as: 1) the rising interest rates (which ought to also include the Fed cutting back on its QE policy, and 2) the difference between the government's 10-year and 2-year borrowing costs are beginning to flash yellow.  

My take and forecast - shared by 40 percent of financial experts - is that the end of this year will see a recession as all of Trump's terrible intrusions into the economy - including his stupid tax cut (for the wealthiest) wreak havoc.  As Paul Krugman observed in his most recent NY Times column:

"Since the tax cut isn’t paying for itself, it will eventually have to be paid for some other way – either by raising other taxes, or by cutting spending on programs people value. The cost of these hikes or cuts will be much less concentrated on the top 10 percent than the benefit of the original tax cut. So it’s a near-certainty that the vast majority of Americans will be worse off thanks to Trump’s only major legislative success."


Couple that with millions hit by the consequences of Trump's tariffs, as well as GOP states' stripping of the ACA to bare bones provisions (e.g. no coverage of preexisting conditions), and you have all the fuel needed for a major recession.  We will see. 
 
 See also:

Energy Policy | Environmental Policy

10 Worst-Case Climate Predictions If We Don’t Keep Global Temperatures Under 1.5 Degrees Celsius

And:

Alexa Beyer

Media | Progressives and the Left

Thanks to Green New Deal Push, Progressives Have Forced Corporate Media to Put Focus on Climate Crisis

   And:

William Rivers Pitt

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Corporate America | Government | Media | Politics

What Fresh Hell in 2019? Your Guess Is as Good as Mine.

by William Rivers Pitt | January 2, 2019 - 7:28am |