Rapid Yield Curve Inversions as Recession Fears Realized
Last week was pandemonium for US Equities, Japanese Equities, Foreign Exchange markets, Cryptocurrency markets, and Bond markets. Yet, for those positioned for the normalization of the yield curve, results are apparent as the curve has officially normalized into positive territory with a sharp recovery on Friday which continued into Monday.
The non-farm payroll report highlighted concerns we previously illustrated that a recession is not off the cards yet.
In fact, the latest data suggests it may be likely. The Sahm rule, a strong indicator of past recessions, was activated based on the latest jobs data.
Given the possibility of a recession in the US, the further steepening of the yield curve remains a compelling opportunity with uncertainty persisting across all areas of the market. This paper provides a hypothetical trade setup in the 10Y-2Y spread to gain exposure to normalization.
LATEST JOB REPORT WAS DISMAL WITH LOW JOBS ADDED, RISING UNEMPLOYMENT
The Nonfarm payroll report from July showed a meagre 114k jobs added compared to expectations of 176k. Even worse, figures for May and June were revised lower by a cumulative 29k bringing the updated figures well below the initial analyst consensus for these months.
Job addition in July was one of the lowest since the pandemic. Moreover, both initial and continuing jobless claims last week rose to their highest level since 2021. Combined effect on the job market was an increase in the unemployment rate to 4.3%, the highest since 2021.
The job market is visibly weakening. Though the effect of Hurricane Beryl likely played a role in the dismal jobs report, the details suggest systemic weakening as both hiring and quits fell to their lowest level since 2020.
To make matter worse, conditions may worsen even further in the coming months as Intel announced plans to reduce its workforce by 15k at its most recent earnings.
JOBS REPORT TRIGGERS SAHM RULE
The Sahm rule is a recession indicator used to identify early signals of a recession. It measures the difference between the current unemployment rate relative to the lowest three-month average in the last 12 months. According to the Sahm Rule, a recession could be on the hoirzon when this value rises above 0.5, Currently, the indicator is at 0.53.
It is a highly accurate indicator, proven to be reliable through the last 12 recessions when the indicator was at present values.
While no indicator is completely accurate and past results do not guarantee future performance, the accuracy of the indicator should not be ignored.
RATE CUT EXPECTATIONS SURGE
As a result of the dismal jobs report, rate cut expectations have surged, largely due to expectations that the Fed will be forced to cut rates rapidly in response to a faltering economy.
For reference, at the September policy meeting, FedWatch signals a >90% probability of 50 basis point cuts. Just 1 week ago, FedWatch suggested a 10% probability for that decision.
Markets are also expecting a 50-basis point cut at the November meeting followed by a 25-basis point cut at the December meeting for a cumulative cut of 125 basis points in 2024.
BOND MARKETS IN TURMOIL BUT YIELD SPREAD SURGED
Due to the rapid reversal in sentiment, US treasury yields have fallen sharply. 2Y yield is 15% lower over the past week. 10Y yield has declined by 10% and 30Y yield has fallen by 8%.
On Friday, the decline in 2Y yield was the sharpest since 13/December when the Fed policy projections suggested up to six rate cuts in 2024. This time around, the decline in bond yield has been driven by market fears of a recession which may force the Fed to cut rates rapidly.
While the yields have declined sharply, yield spreads have surged. The 10Y-2Y spread has increased by 27 basis points over the past week with a 10-basis point jump on Friday followed by another 8 basis points increase on Monday.
The 30Y-2Y spread has been the strongest performer. It has increased by 63 basis points over the past week. It surged by 29 basis points on last Friday and another 14 basis points on Monday.
Both spreads have now normalized as 2Y yield has declined much more sharply than 10Y and 30Y yield. The normalization has brought to end the longest yield curve inversion in history that lasted more than two years.
This is not unexpected as highlighted by Mint Finance in a previous paper. The yield spread tends to normalize long before a recession actually arrives.
However, the spread may rise further. According to historical levels of the 10Y-2Y spreads at the start of previous recessions, there is between 15 and 100 basis points of further upside.
The potential for upside is even higher on the 30Y-2Y spread although in 1989, the level was lower than the current level suggesting the risk of a decline.
LONG 10Y SHORT 2Y ON FURTHER NORMALIZATION
While the movements in the yield spreads over the past week have been enormous, there is a potential for further increase. Recession signals are flashing red. Equity markets are in turmoil. Fed may be forced to reduce rates to support a weak job market.
Rapid rate cuts and a recession support further steepening of the yield curve. Historical performance of yield spreads prior to recessions suggests the yield curve may continue to steepen at a rapid rate.
We had previously suggested the 30Y-2Y spread as a superior instrument to express views on this normalization. However, the 30Y-2Y spread has surged by 63 basis points in the past week. While it may continue to rise even further, there is a risk that markets have exhausted much of the upside. A position on the 10Y-2Y spread offers potentially higher upside.
The 10Y-2Y spread is just above the level of 0 indicating the potential for further recovery. The current 10Y-2Y spread level is far below the levels at the start of previous recessions.
Investors can seize opportunities from normalization in the 10Y-2Y spread using CME Yield futures. The CME Yield futures are quoted directly in yield with a one basis point change in the yield representing a P&L of USD 10.
The below hypothetical trade setup consisting of long 10Y yield futures and short 2Y yield futures expresses a view on the further steepening of the yield spread with a reward to risk ratio of 1.3x.
Entry: 3.7
Target: 27.8
Stop Loss: -15
Profit at Target: USD 241 ( (27.8 – 3.7) x 10 = 24.1 x 10)
Loss at Stop: USD 187 ( (-15 – 3.7) x 10 = -18.7 x 10)
Reward to Risk: 1.3x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
The non-farm payroll report highlighted concerns we previously illustrated that a recession is not off the cards yet.
In fact, the latest data suggests it may be likely. The Sahm rule, a strong indicator of past recessions, was activated based on the latest jobs data.
Given the possibility of a recession in the US, the further steepening of the yield curve remains a compelling opportunity with uncertainty persisting across all areas of the market. This paper provides a hypothetical trade setup in the 10Y-2Y spread to gain exposure to normalization.
LATEST JOB REPORT WAS DISMAL WITH LOW JOBS ADDED, RISING UNEMPLOYMENT
The Nonfarm payroll report from July showed a meagre 114k jobs added compared to expectations of 176k. Even worse, figures for May and June were revised lower by a cumulative 29k bringing the updated figures well below the initial analyst consensus for these months.
Job addition in July was one of the lowest since the pandemic. Moreover, both initial and continuing jobless claims last week rose to their highest level since 2021. Combined effect on the job market was an increase in the unemployment rate to 4.3%, the highest since 2021.
The job market is visibly weakening. Though the effect of Hurricane Beryl likely played a role in the dismal jobs report, the details suggest systemic weakening as both hiring and quits fell to their lowest level since 2020.
To make matter worse, conditions may worsen even further in the coming months as Intel announced plans to reduce its workforce by 15k at its most recent earnings.
JOBS REPORT TRIGGERS SAHM RULE
The Sahm rule is a recession indicator used to identify early signals of a recession. It measures the difference between the current unemployment rate relative to the lowest three-month average in the last 12 months. According to the Sahm Rule, a recession could be on the hoirzon when this value rises above 0.5, Currently, the indicator is at 0.53.
It is a highly accurate indicator, proven to be reliable through the last 12 recessions when the indicator was at present values.
While no indicator is completely accurate and past results do not guarantee future performance, the accuracy of the indicator should not be ignored.
RATE CUT EXPECTATIONS SURGE
As a result of the dismal jobs report, rate cut expectations have surged, largely due to expectations that the Fed will be forced to cut rates rapidly in response to a faltering economy.
For reference, at the September policy meeting, FedWatch signals a >90% probability of 50 basis point cuts. Just 1 week ago, FedWatch suggested a 10% probability for that decision.
Source: CME FedWatch
Markets are also expecting a 50-basis point cut at the November meeting followed by a 25-basis point cut at the December meeting for a cumulative cut of 125 basis points in 2024.
Source: CME FedWatch
BOND MARKETS IN TURMOIL BUT YIELD SPREAD SURGED
Due to the rapid reversal in sentiment, US treasury yields have fallen sharply. 2Y yield is 15% lower over the past week. 10Y yield has declined by 10% and 30Y yield has fallen by 8%.
On Friday, the decline in 2Y yield was the sharpest since 13/December when the Fed policy projections suggested up to six rate cuts in 2024. This time around, the decline in bond yield has been driven by market fears of a recession which may force the Fed to cut rates rapidly.
While the yields have declined sharply, yield spreads have surged. The 10Y-2Y spread has increased by 27 basis points over the past week with a 10-basis point jump on Friday followed by another 8 basis points increase on Monday.
The 30Y-2Y spread has been the strongest performer. It has increased by 63 basis points over the past week. It surged by 29 basis points on last Friday and another 14 basis points on Monday.
Both spreads have now normalized as 2Y yield has declined much more sharply than 10Y and 30Y yield. The normalization has brought to end the longest yield curve inversion in history that lasted more than two years.
This is not unexpected as highlighted by Mint Finance in a previous paper. The yield spread tends to normalize long before a recession actually arrives.
However, the spread may rise further. According to historical levels of the 10Y-2Y spreads at the start of previous recessions, there is between 15 and 100 basis points of further upside.
The potential for upside is even higher on the 30Y-2Y spread although in 1989, the level was lower than the current level suggesting the risk of a decline.
LONG 10Y SHORT 2Y ON FURTHER NORMALIZATION
While the movements in the yield spreads over the past week have been enormous, there is a potential for further increase. Recession signals are flashing red. Equity markets are in turmoil. Fed may be forced to reduce rates to support a weak job market.
Rapid rate cuts and a recession support further steepening of the yield curve. Historical performance of yield spreads prior to recessions suggests the yield curve may continue to steepen at a rapid rate.
We had previously suggested the 30Y-2Y spread as a superior instrument to express views on this normalization. However, the 30Y-2Y spread has surged by 63 basis points in the past week. While it may continue to rise even further, there is a risk that markets have exhausted much of the upside. A position on the 10Y-2Y spread offers potentially higher upside.
The 10Y-2Y spread is just above the level of 0 indicating the potential for further recovery. The current 10Y-2Y spread level is far below the levels at the start of previous recessions.
Investors can seize opportunities from normalization in the 10Y-2Y spread using CME Yield futures. The CME Yield futures are quoted directly in yield with a one basis point change in the yield representing a P&L of USD 10.
The below hypothetical trade setup consisting of long 10Y yield futures and short 2Y yield futures expresses a view on the further steepening of the yield spread with a reward to risk ratio of 1.3x.
Entry: 3.7
Target: 27.8
Stop Loss: -15
Profit at Target: USD 241 ( (27.8 – 3.7) x 10 = 24.1 x 10)
Loss at Stop: USD 187 ( (-15 – 3.7) x 10 = -18.7 x 10)
Reward to Risk: 1.3x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Full Disclaimer - linktr.ee/mintfinance
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