A CRITICAL START SIGNAL IN THE MIDDLE
EDU DDA July 8, 2024
Summary: Over the last couple of weeks, the UST yield curve’s 5-year to 10-year spread has un-inverted and steepened. This is potentially a critical first step signaling the wider trend for the marketplace though also just as importantly the economy. Unfortunately, it isn’t so easy and simple. Here we’ll review the developments and some historical cases to see what we can make of all this.
The signals are building toward the next leg in the Treasury rally as the US economy shows more signs of clear recession-like weakness. So much so, it’s hitting the usually-overly-optimistic mainstream sources. There is a potentially strong one in the middle of the yield curve. I’ve long been a proponent of the 5s10s spread, the very belly, because of how much of financial life is conducted there or at the very least strongly tied to it.
This spot on the curve has un-inverted over the past two weeks in a way that does begin to suggest bull steepening. The question is how much steepening would be “enough” to make any confident determination either for the interest rate markets or the economy in general. Typically, though not always, the bull case is bullish for bonds because a full-blown recession has developed or is just about to.
We only need to turn the clock back to last fall for an example of complications. The bull steepening did precede the historic rally in bonds, so there’s the bull, however we can’t yet make any determination about recession. And it didn’t go all the way. Considering what has developed in the US labor market since then, there is a better-than-good chance a contraction has already formed and we’re just getting the lagged signals from it now.
I am always wary of making quantitative-based assumptions or using static “rules” when judging conditions or potential triggers. We live in a dynamic world so it isn’t safe to presume that a “threshold” which appears to have been significant many years ago would continue to be so far into the future given how much might have meaningfully changed in between.
In other words, I don’t believe we can, for example, use something like a 10-bps un-inversion or steepening in the 5s10s part of the curve as a solid trigger. It may be, though more evidence is always required. In spite of all the math and numbers we might muster, it’s all opinion anyway in the end.
And that’s before considering the imperfections and oft-times inefficient signals we get from even the most useful marketplaces. No market is going to be highly efficient and yield (or any) curves aren’t perfect by any means. False indications and triggers abound in every historical case, oftentimes the signals get murky, messy, and downright screwy (as we’ll see).
With those caveats in mind, the ongoing rise to the unemployment rate becomes more and more difficult to dismiss or mischaracterize (as the Fed is currently doing), especially since for the longest time it was used as proof positive the labor market was on the most solid of ground (at least when it was at or near its 50+ year low). In light of more unemployment, we’re getting an increasing number of anecdotal evidence of substantial shifting from around just Wall Street.
The rate cut “trade” has become popular once again using derivatives and options. A number of them have been established paying off if or when short-term rates take a substantial dive as they would once the FOMC realizes its members have made a big macro mistake. One of those is a play on the middle where mid-term rates like the 5s decrease at the same time ultra-long yields like the 30s go up.
As usual, the mainstream media has all the wrong causes and effects, tying the current “steepening” between the 5s and 30s to Trump’s election prospects.
The bet — that the US yield curve will normalize toward a steeper slope — is suddenly looking as good as it has in months, with traders eyeing the latest print of the consumer-price index due this week for additional support… The idea is that the Republican’s policies on tariffs, immigration and deficits will lead investors to demand higher yields on longer-maturity Treasuries. The next leg up in the trade came Friday, when fresh signs of a softening job market bolstered expectations that the Federal Reserve will cut interest rates this year, spurring a sharp drop in short-dated yields.
No, LT rates will rise as the middle sags into the recession window. It has nothing to do with Trump, politics or the never-ending myth UST yields are somehow a reflection of the credit characteristics of the US government. The past several years of wartime level deficits, and no response in rates, have utterly disproved that particular myth.
It gets repeated because Economists refuse to acknowledge how interest rates are an imperfect yet fundamental expression of macro and monetary properties that quite often don’t align with Economists.
While Wall Street traders are once more piling into the middle, theirs and other strategists are likewise becoming more negative on the macro side. As a result, thoroughly mainstream top-tier names have grown pretty bold in their pessimism. Citigroup’s chief Economist is now forecasting eight successive 25-bps rate cuts out of the Fed beginning in September.
Andrew Hollenhorst and his team cited the unemployment rate, the ISMs, even the sharp drop in temp jobs in the June payroll report, claiming (correctly) each is something you expect to find as a recession begins – or, in this case as I believe, deepens enough to have led to the cleanest downturn signals yet.
Moreover, Hollenhorst put Citi’s name in with a growing list paying (pun intended) less attention to the headline payroll series and giving far more weight and consideration to the HH Survey overall and not just its unemployment rate. Those point to dramatically weaker economic fundamentals than is allowed for by the FOMC.
And if that’s right, it doesn’t matter if Jay Powell sees rate cuts the same way right now, he won’t have a choice but to come around soon enough.
With more interest in recession mechanics, this critical 5s10s spread has un-inverted again. It has done so numerous times over the past several months going back to January, though never by more than a basis point or two. It would reach a small positive spread then turn right around and invert all over again.
Since June 25, however, this un-inversion has gotten up to 6 bps enough to stick right out on the chart. As noted above, I don’t consider that or any specific level to be a trigger threshold, instead as you can see it merely hints that something may be changing in the marketplace to go along with the data and these anecdotes.
To begin with, look at how the 5s10s behaved last year preceding the big rally. The only other time the 5s10s un-inverted this cycle was for a brief two weeks beginning the days right after First Republic failed in May 2023. That gives us another dimension to consider, not just how much the spread might un-invert also how long it stays that way.
That’s also a constant feature of past episodes including; if the spread does un-invert, it can’t do so for a day or even a week or two, it has to stick. And by “stick” it doesn’t necessarily have to be constant, though that makes the strongest case.
Looking back at the 2007 cycle, showing just how difficult and uncertain the “best” markets can be, the 5s10s spread bear steepened between the end of February and April 2007 while nominal yields would rise all the way until mid-June before everything turned around once the monetary and macro conditions decisively deteriorated against the economy and the eurodollar system.
The initial bull steepening at the end of June wasn’t as clear and unambiguous as we would’ve liked, either, as the market’s confidence in the darker scenarios faltered a little bit entering July. It wasn’t until later in the month the market finally made its most conclusive move – the 5s10s steepened wildly as did the rest of the curve only a couple weeks before August 9 and the escalation into the full-blown Global not-Financial Crisis.
Leading up to the dot-com recession period, the 5s10s bull steepened a couple months before the 2s10s, for example, and about five months prior to the official cycle peak (February 2001). Alan Greenspan’s Fed began cutting rates in early January 2001 two months after that part of the bond rally had gotten going.
It was the decisive move in the spread which made the initial strongly compelling signal. During the first couple weeks in early November 2000, the 5s10s un-inverted to 6 bps (where it is right now) then slipped back to zero before widening into early December, narrowing a few bps again, before finally taking off steepening by mid-December right on through the rest of the cycle.
There isn’t much lead time after the big move shows up, so when it does that one not only confirms the bull steepening case it can be a useful timing signal, too.
Going back to the late eighties leading up to the S&L recession, the curve changes were all over the place. The 5s10s were heavily inverted from 1988 leading into a monster bond rally from March 1989 while the spread narrowed (still inverted) only to un-invert in significant fashion just as that rally was reaching its end.
Yields went up from the beginning of 1990 re-inverting the 5s10s briefly that March, before un-inverting in April while rates surged then dropped as the spread also reversed. It wouldn’t make a definitive move until July. Even then, yields at first jumped (oil prices after Saddam and Kuwait triggered widespread believe Greenspan would hike) before finally the big rally in the final months of the year as the full-blown contraction broke out into the labor market removing any chance of interference (hikes) at the front end by the Fed.
The early nineties cycle is a good reminder of how messy these processes can be and very often are, why it’s therefore so difficult to make easily conclusive determinations.
Keeping that in mind, there are a few helpful suggestions and takeaways. The 5s10s spread can be a leading indicator for the bull steepening in the market which does signal fuller and more widespread recognition of macro deterioration. The economy may have already turned, yet it isn’t always so clear for when the inflection gets made.
A sizable move in the 5s10s only begins the process, however, recognizing there is more art in the term “sizable” right from the start. Once it happens, like now, then we might at most be on the lookout going in both directions meaning also being aware of the potential for a false signal or head-fake. The opposite, confirmation of the bull steepening and recession, is going to be confirmed by other spreads on the curve plus mounting evidence throughout data and in trading elsewhere.
Furthermore, we want to see this one and the others make the un-inversion stick. And if it should widen substantially, all the more conclusive.
Right now, we’re just at the first step. The 5s10s has come un-inverted again and to enough of a degree we can tentatively start to consider the possibility. As we do, last year’s steepening into the rally is another example of how muddled and involved the process can be.
Having written all that, a strong and compelling case for bull steepening has been building up for quite some time this year, so the 5s10s flipping like they have only adds a little more meaning and emphasis to it. That’s more than enough to really begin taking the possibility seriously. It would be nice and so much easier if we could assign quantitative dimensions – say, 10-bps un-inversion which holds for at least two solid weeks – but we aren’t that lucky.
Did the recession, if that’s what we’re getting, actually start last October? If it did, that would make the bull steepening highly unusual with the length of time in between legs, not to mention everything that happened in the economy in between including “sticky” CPIs. Then again, we’re in the midst of one of the most unusual cycles imaginable, filled with all kinds of unique circumstances. Its defining feature thus far is the incredibly elongated time period, so maybe that’s just how this one will go and be different.
