Coming to Terms With The Fed and Curve Inversions (Do They Matter?)

The order of business this week has been fairly simple.  The market had been telling itself that the Fed would end up cutting rates by the end of 2023 while the Fed had been telling the market that rates would remain at the ceiling level for quite a bit longer.  Friday's jobs report put the market in the mood to listen.  Powell delivered the message gently on Tuesday.  Williams delivered it more forcefully on Wednesday, but the market had already acquiesced by pricing in at least another 25bp hike in 2022 and completely pricing out the previously foreseen rate cut.  The rest of the week is anyone's guess at this point.  Markets look like they've found their footing and there's no new major data to cause a stir.

The most actionable items on the calendar after the Fed comments in the first half of the week have been the Treasury auctions.  We saw this with yesterday's 10yr auction and we may see another reaction after today's 30yr auction.  Once again, the longer-end of the yield curve (i.e. 10-30yr bonds) is one of the only ways the market can bet on inflation and growth calming down in a world where the Fed says it is keeping short-term rates higher regardless.

The more the market believes the Fed is true to its word, the more we see the yield curve "invert" (i.e. 2yr yields rise higher above 10yr yields).  Here's a longer term look at the curve:

And here's a simpler way to understand what the green line means.  In the following chart, we would just subtract the red line from the yellow line to get the green line above.  If the red line is higher than the yellow line, the curve is inverted (i.e. the green line in the chart above is in negative territory).

Many people will point out that an inverted curve is a surefire predictor of recessions.  It's true that inverted curves frequently precede recessions, but so does everything else.  Recessions happen periodically.  How long will we wait before the next recession and still insist that this curve inversion is what caused it?  The inversion itself doesn't CAUSE a recession.  It's a symptom of a climate of financial conditions that increases the odds of recession, perhaps.  

More importantly, we are operating in a different reality than all of the past examples of curve inversions.  None of the previous recession-predicting examples occurred in a world with Fed QE.  And only the inversion from 1980 occurred in an environment with higher inflation or a tougher Fed policy outlook (that inversion was twice the size of this one, for what its worth).  QE may be unwinding, but it is still exerting some downward pressure on longer term rates, all other things being equal.  

Past inversions also occurred amid much higher outright rates.  The Fed's zero rate policy over the past decade and post-covid meant that short-term rates had nowhere to go but explosively higher once it was time to tighten.  It absolutely makes sense for the curve to be inverted (heavily) and it's really our only shot at a soft landing.  A recession would be FAR more likely (and far more devastating) if the curve were not inverted right now, all other things being equal.  

Bottom line: the inversion is a byproduct of other things that have happened; other things that we already know and understand.  It's a symptom and an effect before it's a root cause or discrete development.