Another Inverted Yield Curve with Even More Predictive Power

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The Federal Reserve Chair Jerome Powell spoke again today at a Brookings Institution event. His comments sparked a rally in markets (likely including short covering) that pushed the S&P 500 up about 122 points, or 3.10%, to close at 4080. The Nasdaq 100 rose 4.58% on the day, closing at 12,030.

But the bond market is sending less sanguine signals. The 10Y/3M yield curve inverted further today. Its inversion is currently the deepest since the slightly deeper inversion of this segment of the yield curve in 2000-2001 inversion, which had presaged the 2-year bear market from 2000-2002.

The 10Y/3M curve has been researched more than the more widely known 10Y/2Y curve (also known as the 10s/2s). Experts say inversions of the 10Y/3M serve as better predictors of recession than the 10Y/2Y curve.

The yield curve has remained inverted for over a month now. This qualifies as a "persistent inversion" that creates a recession signal. But the recession does not always follow immediately. According to Jim Bianco of Bianco Research LLC, "The average lead time" until the recession arises "is 311 days, or about 10 months."

What does this offer for traders then? On days when equity markets are rallying like there is no tomorrow, it tells us that markets are not out of the woods despite the buying frenzy. It means that a recession is more probable than not in the next year. But it doesn't tell us much about where prices are headed in the near term (technical analysis of price itself works better for this purpose). Just because a recession will likely begin in the coming weeks or months does not necessitate that equity markets plummet in a straight line to the ideal target. Many, including this author, wishes it could be as straightforward and predictable.

So traders should also keep in mind that inverted curves are not a trading signal. They are part of the broader economic and rate-policy context within which equity markets operate. It helps me to know that markets are not likely to resume a long-term uptrend until the recession has ended.

The bond market tends to sniff out the problems in the economy long before other markets. And equity markets can ride on hope and desperation for much longer than anyone expects—just as this unexpected bear rally carried SPX price from the October 13, 2022 low all the way back above the 200-day MA today and higher to close at 4080.11.

Below is a chart of the 10Y/2Y yield curve, which is also inverted.

Supplementary Chart A:

To compare the current 10Y/2Y inversion with some historic inversions, consider reading this prior post from July 2022 on the 2s / 10s yield curve inversion, and be sure to hit the refresh button to see the most recent months of data. The Wall Street Journal Confirmed in recent days, by the way, that the 2s / 10s curve

Supplementary Chart B:

Yield Curve Inversion Continues: More Pain Ahead Later?

Finally, on a monthly chart, one can easily see that the 2s / 10s curve inversion is the deepest one on record—at least as far back as the chart allows. Hat tip to spy_master for pointing this record-breaking inversion recently.

Supplementary Chart C:

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Bank of America published a chart a few days ago showing the 2s10s yield curve and recessions. The main point was that the curve's steeping (moving out of inversion territory) was typically when a recession would begin. This point was well-illustrated on the chart, which dated back to 1960s and showed all the major recessions and inversions together. All the recessions were shaded areas, and showed the yield curve steepening dramatically at the start (or during) the recessions going back to 1970

Another well-researched point made by fund managers and other financial experts recently is that bear markets do not end *before* the recession begins. So if there is a recession (and the yield curves above strongly suggest there will be), then the bear market will not end, based on historical example, before the recession has begun.

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Correction: The reference to the Wall Street Journal's article on the 2s / 10s yield curve should read as follows:

The front page of the Wall Street Journal mentioned in recent days, by the way, that the 2s / 10s curve had inverted to the deepest level since 1981. twitter.com/elerianm/status/1597902436701802496

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Some of the comments have been appropriately discussing the irrationality of the markets move yesterday (and some of the big pushes off the 10/13 lows should probably be included) given the macro and the lack of a real pivot.

One veteran trader's approach to trading the rally yesterday is shown in the linked video below. Brian Shannon said in the comments he didn't listen to a word of Powell's speech yesterday but just traded price action, which told him all that he needed to know. ST is not endorsing Shannon's approach for anyone, and by the way, he uses strict risk management. But check out this video and the tweet's around it. It's helpful to learn as a way to flow with price action, trading it level to level rather than fighting it.

The macro is relevant. Longer term uptrends are not likely to be sustainable. But staying open minded to short-term price action is helpful for the trading account. Could price rise back to all-time highs? Unlikely given the macro / rate environment. But if it starts happening, don't fight it since price remains preeminent. And if it happens, ST will continue to view it as untrustworthy given the macro and inversion in yield curves.

twitter.com/alphatrends/status/1598063307742916608

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One commenter below asked the following question: "Which recession in history started after a 25%+ downturn?"

This has an easy answer within the past 20 years: the 2000-2002 crash. The bear market started in 1Q 2000. The recession officially began in 3/2001. The bear market ended in 9/2001 after falling another -40% from the peak of the bear rally that followed after the low that occurred 3/2001.

There may be more than one example of this. There may be other TV members with good macro expertise who may wish to comment on other examples of this.

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The 10y-3m spread (the most well-studied segment of the yield curve as to predicting recessions per
Jim Bianco) has inverted more deeply to new lows. It is now deeper in inversion territory than any other year on this chart, which goes back to 1990.

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Since this post was published back in late November 2022, the 10y/3m yield curve has inverted even more deeply into negative territory. TradingView's yield charts don't go back far enough, but for all the data shown by TV, the inversion is a record. Liz Ann Sonders of Schwab posted a chart the other day showing that it was the deepest inversion since 1981, which is 42 year record!

Also, look at when the recessions begin. Recessions are in orange. They tend to begin when the curve begins to climb out of negative territory.

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The inversion persists at record levels. This post was initially dated November 30, 2022. The inversion in this segment of the yield curve has now existed for more than 3 months including a week or so in October 2022, followed by a brief move out of inversion territory, and since early November 2022, this has remained deeply inverted.

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Here is the 2s/10s yield curve -- a different segment of the yield curve than what was discussed in the original post above. But this one is still considered.

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Yield curve 6 months ago (October 5, 2022 in blue) and currently (April 5, 2023 in red):
ustreasuryyieldcurve.com/b/82PhCR

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Check out the yield curve inversion (monthly chart updated through today—note this month's bar is not yet closed)

You can also update the primary chart at the top of this post by clicking the arrow that refreshes and updates the chart.

As stated in my February 2023 update, the inversion persists at record levels. Since February, new record levels of inversion have occurred.
This post was initially dated November 30, 2022. The inversion in this segment of the yield curve has now existed for about 6 months plus a week or so in October 2022, followed by a brief move out of inversion territory.

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The inversion in this segment of the yield curve has now existed for about 8 months. No recession yet. And equities don't seem to care yet.

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Update on the 10Y-3M yield spread. This segment of the yield curve has now been inverted for about 9 months.

The inversion has moved off its lows a bit, however, over the past few weeks. The rapid rise in 10Y note yields and 30Y bond yields after the Fitch downgrade has affected the 10Y/3M segment as the 10Y yield has risen relative to the 3M yield. No one knows when the "credit events" or "recession" starts that causes a rapid normalization of this portion of the yield curve. But when this yield curve uninverts tends to be when traditionally equity markets come under intense selling pressure.

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And here is an update giving a visual of the whole yield curve today versus one month ago.

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The US Treasury yield curve today versus four months ago:

The yield curve continues to show inversion, but it also shows some degree of steepening, known as bear steepening. Notice how long-end rates have risen in the past four months while short-end rates haven't changed much. This doesn't mean equities and other risk assets must fall tomorrow, next week, or next month. It just means there are problems in the macro environment that will lead to volatility and more trouble ahead, though we can't pinpoint exactly when. It's just something to keep in mind as commentators continue to discuss a soft landing (and remember, a few months ago, experts were glibly referring to "no landing").