Yield curve flips to positive again. Celebrate?

Still under water at the short end

Last week saw a big development in financial markets. The two most widely monitored measures of the US Treasury yield curve are inverted no more. In other words, the yields on both the three-month bill and the two-year bond are once again lower than the 10-year yield, having briefly and very unusually been higher:

We pay attention to this arcana because an inverted yield curve is possibly the most reliable indicator of an oncoming recession. The three-month/10-year curve has a great record, coming ahead of every recession since war, with no false positives and no false negatives. An inversion should be sustained for a while to send a clear signal, and the twoyear/10-year inversion only lasted a few days in August.

But sadly, this un-inversion does not mean that the previous recession signal has been reversed. As Bloomberg Opinion contributor Jim Bianco points out, this inversion has already persisted long enough to send a strongly negative signal about the economy. The inversions of 1969 and 1989 were shorter, and both were followed about a year later by recessions.

It’s true that Friday brought great optimism over the US-Chinese talks. But these are yet to address any of the toughest issues. At no point in the last 18 months has either side removed a tariff once it has been imposed. With Trump in trouble over the impeachment inquiry, and Chinese authorities confronted by the unrest in Hong Kong, game theory suggests that neither side wants to push this confrontation further for a while. But there’s scant sign of a lasting resolution.

Meanwhile, the yield curve cares a lot about the Fed, and about liquidity. There has been a scarcity of shortterm instruments of late, which led to serious problems in the repo market. The Fed has still not completely sorted this out. The threemonth bill still yields more than the two-year bond, but there has been a sharp move. (This spread is not a good recession indicator)

The yield curve moves should be seen as the result of an all-out effort by the Fed to gain control of the curve once more, having lost it during the period when it was trying to reduce its balance sheet. Their intervention is a big deal.

As TS Lombard’s US economist Steven Blitz puts this, the Fed’s actions are “an ease in the short-term worth some basis points” which have reversed a year’s worth of balance sheet reduction. The steepening of the curves, and Friday’s general enthusiasm for risk assets, show that the market gets that message; the Fed is determined not to cause any accidents.

According to Blitz, the Fed is trying calm down worries about liquidity, so that it can then tell the market something that it doesn’t want to hear at the FOMC at the end of this month — that it isn’t cutting the Fed funds rate and that it hasn’t embarked on a major campaign of monetary easing.

So, it’s not QE, but the Fed is regaining control of the market. It does not show that the Fed will continue to be generous. Neither does it show that the market is bullish about growth. As for the notion that the inversion portended a recession in the US by the end of next year, it still stands. — Bloomberg