UST Curves: Slope Matters
We trace the history of peak inversions in 1980, 1980, 2000, 2006, and now. Inversions are hard to see with ZIRP and QE.
Summary
I like to track UST curves for a range of reasons, but the main theme is around compensation for extension out the curve and the “penalty” for being in cash. My favorite is the 3M-5Y slope since it has a direct impact on asset allocation and notably the allocation to cash and loans vs. fixed rate instruments out the curve (see The Cash Question: 3M-5Y Yield and Slope). The 2Y-10Y slope is a broader market favorite since it cuts across the sweet spots of both the IG and HY markets and is embraced as a reliable predictor of recession risk by the equity markets. Most of the UST segment inversions (3M-5Y, 2Y-10Y, and 2Y-30Y) line up reliably ahead of downturns, but in my view fundamental trenches bring the cause-and-effect while the UST slope is the symptom. The curve shape has some value as a second opinion, but it mostly serves as a variable in relative value across asset classes and for maturities along the yield curve.
The 2Y-10Y and 2Y-30Y also plays into the themes around how much compensation the curve extension offers to the corporate bond investor whether in UST curve slope or in terms of incremental spread. In recent months, the more typical financial media commentary has curve inversion as the critical signal for recession risks. The equity markets like the shorthand of that 2Y-10Y inversion number and tracking its direction. The fact that the UST curves sometimes revert to upward sloping before the more severe pain sets in has not spoiled the inversion party for most.
Above we plot the 2Y-10Y slope back across time. We see some very steep curves in 1992, 2003, 2011, and 2013. We see a much lower peak steep slope in March 2021 when the longer end was moving higher, and the short end was still artificially low. The risk bulls were loose in March 2021 and especially in growth equities. The Fed did not start its tightening cycle and get off the ZIRP train until March 2022, so that left a lot of room for excess. Many IPOs and SPACs paid the price in 2022.
The array of distortions after the 2008 credit crisis factor into the timeline with early 2011 and 2013 still in a ZIRP world. We also saw some systemic nerves getting frayed around the Eurozone stress from May 2010 through fall 2011 (with a brief revisit in May 2012). The taper tantrum of 2013 also sent the curve steeper as equities had a very strong year while US HY materially outperformed higher quality, longer duration classes.
The mini-inversion of late 2019 for 2Y-10Y (-5 bps in Aug 2019) was not saying much compared to the bigger inversion of the 3M-5Y in 2019. The market debated recession risk in late 2019 and what might happen in 2020 as trade wars were weighing on capex. The par plus dollar price in US HY to start 2020, an impressive solid equity rebound in 2019, and a number of other indicators were pushing back hard on recession risk in 2020. Everyone knows the arrival of COVID in Feb 2020 in Europe and its US explosion in March ended those debates.
As we cover in other commentaries, the 1979 volatility (e.g., Iranian oil crisis) and very aggressive inflation fighting game plan (reminder: Paul Volcker arrived in Aug 1979) was soon wreaking a lot of havoc. The spiking short end rates were set against a high inflation backdrop that still included a positive GDP growth year for 1979 (+3.2%) on the way into a negative GDP year in 1980. The recession of 1980s and spiraling inflation brought record highs in the Misery Index of 22% by June 1980 (see Misery Index: The Tracks of My Tears).
The peak inversion shown above in March 1980 was more a coincident indicator during a time of economic trauma than “leading” when a massive dose of economic pain was already unfolding. The double dip recession ended in Nov 1982. Anyone not aware of major economic risks by the end of 1979 had to have been in an isolation ward (I graduated from college in June 1980 and had picked Iran as a thesis topic a year prior). The Business Cycle Dating Committee was wrestling with that one.
Like the 2Y-10Y, the inversion of March 1989 was ahead of the broader market by a few months. I’ve already covered how bad the credit markets were hit as credit cycle peaked in 1989. Meanwhile, the equity market kept rocking in 1989 (see Greenspan's First Cyclical Ride: 1987-1982). The Business Cycle Dating Committee called the peak much later in March 1991 (see Business Cycles: The Recession Dating Game), but the FOMC and market price actions were on their own game clocks. The credit markets were well ahead of schedule in 1989-1990. Drexel, who was an iconic force in HY bonds and liability management for leveraged issuers, was bankrupt in early 1990.
The TMT years was another period of disconnects. The May 2000 peak inversion came as the TMT bubble was deflating and shortly after the March 2000 NASDAQ peak. The credit cycle was clearly over by 1999 (arguably during 1998 in my view), so the 2Y-30Y gets no points for predictive value here. The market was already entering the longest default cycle in history. The Fed went wild in its easing process well into the expansion and fed funds was at 1.0% to start 2004. Then the flattening came on with a vengeance as detailed in the yield charts below.
The inversion of early 2006 gets a “win” since it occurred just after the end of the peak year for housing (2005) and during a period when the credit and equity markets were flying high. Leveraged finance markets were smoking hot until they realized the house was on fire in the middle of 2007. In a small amount of fairness to the credit markets (and the smartest guys in the room minting money and setting records in LBOs), the real problem was over in the RMBS market and in some of the more “creative” offerings in structured credit.
In 2006 and 2007, overall systemic corporate sector leverage was not the problem. Reckless mortgage underwriting from the local lenders to the international packagers brought a mentality of “print ’em all and sort ’em out later” to mortgage lending. Some of the big brokers went off the rails in leverage and their commercial paper funding dependence was a liquidity-risk-too-far when the money funds got spooked. Some of those brokers are no longer with us. Others merged with banks or got their Banking Holding Company union card. The sense of blank check derivative counterparty lines in underwriting and hedge fund ranks, low bars at the rating agencies on acceptable (or unavailable) disclosure, and systemic bank interconnectedness blindsided a lot of players in equity and credit. We know how that ended.
Whenever I plot a “net number” such as UST slope, quality spread differentials, or incremental yield, I always double check the gross numbers used as inputs as I try to make sure I have my ducks in a row. The chart above plots the absolute yields (in basis points since the 2Y UST got so low) from 1986 to current times. I picked 1986 since it was four years into the expansion and had a 1% handle CPI year. Starting with the Volcker stagflations war would have messed up the visual scale.
We see the divergences of the short and longer end of the UST curve after the post-1980s default cycle and recession that also saw an extended period of bank system and thrift stress. That period also “tagged” a few brokers (Drexel, Lehman, Kidder, First Boston) that the Fed had to be watching out of the corner of one eye (The SEC regulated the brokers). The 9% handle fed funds of 1989 were a long way off by 1992.
We saw another round of Fed support “overtime” after the TMT bubble burst with the 2Y UST still down in a low 1% handle in June 2003 and fed funds starting 2004 at 1%. Then the rapid-fire tightening of 2004, 2005, and 2006 changes the slope quickly. The future got tough in later 2007. Essentially, the series of explosions started in the late summer of 2007 until it all blew up in fall 2008. That is covered elsewhere in our cycle series.
The post-crisis ZIRP period (post fall-2008) is when the extended low UST curve is seen in the chart. The same is seen in the COVID recovery period. Where the market is today shows the 2Y UST above its median from 1986 to 2022 while the 10Y UST is closing fast on its median. We will soon see what else the Fed has on its mind in November.