What Makes this Yield Curve Inversion so Different?
Updated
An Inverted yield curve in the context of a 2% inflation environment holds a different meaning than, an Inverted Yield Curve in a high inflation environment......
Market Expectations of Disinflation led to this Inverted Yield Curve:
The Nominal Inversion of the yield curve is caused by the expectation that inflation will fall steadily. Believe it or not an Inverted Yield Curve is the best case scenario for the Fed. A Nominal Inversion during a high inflation period shows that markets have confidence/belief in the Fed's Policy to bring inflation down to 2%. Most of the inversion seen in the yield curve today is nominal....
The Nominal Yield Curve vs. the Real Yield Curve:
Nominal Yield – Real Yield = Breakeven Inflation Rate.
Real Yield = Nominal Yield - Breakeven Inflation Rate
The Breakeven Inflation Rate represents what inflation would have to be in order for investors to “break even” when buying a bond. The general thought process is: If you believe the inflation rate will be greater than the breakeven rate buy Treasury Inflation-Protected (TIP) bonds.
Notice how the Yield Curve for Nominal Yields is a lot more Inverted than the Yield Curve for Real Yields. Hence, the inversion in today's Yield Curve is mainly nominal. Below I calculate out the Real Yield for the treasuries with Breakeven TIP Data from FRB St.Louis.
Nominal Break-even
US02Y: 4.3% - (RealYield) = 3.0% = 1.3% RealYield for US02Y
US05Y: 3.6% - (RealYield) = 2.3% = 1.3% RealYield for US05Y
US07Y: 3.6% - (RealYield) = 2.4% = 1.2% RealYield for US07Y
US10Y: 3.4% - (RealYield) = 2.2% = 1.2% RealYield for US10Y
US10Y/US02Y Nominal Yield Curve: 3.4% - 4.3% = -0.8% (Inverted)
US10Y/US02Y Real Yield Curve: 1.2% - 1.3% = -0.1% (Inverted)
The bond market expects for inflation to remain above trend the next 1-2 years and decrease dramatically after that. As you can see, the nominal yield curve is very inverted even though, the real interest rate is pretty much held constant across thee curve. The Real Interest Rate remains between 1.3% and 1.2%. The Yield Curve Inversion in Nominal terms is: -0.8% and in Real Terms is: -0.1%.
Partners in Crime: Unemployment and the Yield Curve:
When consumers start to save more, companies start to see earnings deteriorate. In turn, they cut costs by letting workers go. The US10Y/US02Y yield curve is a proxy for Unemployment. Unemployment rises as, the market starts to expect rate cuts from the fed. It is only when the spread on the US10Y/US02Y starts trending up does unemployment start to rise. The spread of the US10Y/US02Y yield curve starts to trend upwards when the 2 year rate plummets as, markets start to price in a recession. Currently, the Yield Curve is still declining signaling that unemployment will remain low.
So what does this all mean???
A recession is not as close as many people are saying. People have been calling for a recession since April. This yield curve also signifies that markets are more or less believe that the fed will engineer a soft anding and bring inflation back to the 2% target. If you don't believe the disinflationary narrative spread by the fed there is an opportunity for you to make money on what markets are mispricing.
What will you do the next time a fake guru waves an inverted yield curve in your face to scare you into a subscription?
Market Expectations of Disinflation led to this Inverted Yield Curve:
The Nominal Inversion of the yield curve is caused by the expectation that inflation will fall steadily. Believe it or not an Inverted Yield Curve is the best case scenario for the Fed. A Nominal Inversion during a high inflation period shows that markets have confidence/belief in the Fed's Policy to bring inflation down to 2%. Most of the inversion seen in the yield curve today is nominal....
The Nominal Yield Curve vs. the Real Yield Curve:
Nominal Yield – Real Yield = Breakeven Inflation Rate.
Real Yield = Nominal Yield - Breakeven Inflation Rate
The Breakeven Inflation Rate represents what inflation would have to be in order for investors to “break even” when buying a bond. The general thought process is: If you believe the inflation rate will be greater than the breakeven rate buy Treasury Inflation-Protected (TIP) bonds.
Notice how the Yield Curve for Nominal Yields is a lot more Inverted than the Yield Curve for Real Yields. Hence, the inversion in today's Yield Curve is mainly nominal. Below I calculate out the Real Yield for the treasuries with Breakeven TIP Data from FRB St.Louis.
Nominal Break-even
US02Y: 4.3% - (RealYield) = 3.0% = 1.3% RealYield for US02Y
US05Y: 3.6% - (RealYield) = 2.3% = 1.3% RealYield for US05Y
US07Y: 3.6% - (RealYield) = 2.4% = 1.2% RealYield for US07Y
US10Y: 3.4% - (RealYield) = 2.2% = 1.2% RealYield for US10Y
US10Y/US02Y Nominal Yield Curve: 3.4% - 4.3% = -0.8% (Inverted)
US10Y/US02Y Real Yield Curve: 1.2% - 1.3% = -0.1% (Inverted)
The bond market expects for inflation to remain above trend the next 1-2 years and decrease dramatically after that. As you can see, the nominal yield curve is very inverted even though, the real interest rate is pretty much held constant across thee curve. The Real Interest Rate remains between 1.3% and 1.2%. The Yield Curve Inversion in Nominal terms is: -0.8% and in Real Terms is: -0.1%.
Partners in Crime: Unemployment and the Yield Curve:
When consumers start to save more, companies start to see earnings deteriorate. In turn, they cut costs by letting workers go. The US10Y/US02Y yield curve is a proxy for Unemployment. Unemployment rises as, the market starts to expect rate cuts from the fed. It is only when the spread on the US10Y/US02Y starts trending up does unemployment start to rise. The spread of the US10Y/US02Y yield curve starts to trend upwards when the 2 year rate plummets as, markets start to price in a recession. Currently, the Yield Curve is still declining signaling that unemployment will remain low.
So what does this all mean???
A recession is not as close as many people are saying. People have been calling for a recession since April. This yield curve also signifies that markets are more or less believe that the fed will engineer a soft anding and bring inflation back to the 2% target. If you don't believe the disinflationary narrative spread by the fed there is an opportunity for you to make money on what markets are mispricing.
What will you do the next time a fake guru waves an inverted yield curve in your face to scare you into a subscription?
Note
Additional Detail on the calculation:Nominal Yield - Breakeven = Real Yield
US02Y: 4.3% - 3.0% = 1.3% RealYield for US02Y
US05Y: 3.6% - 2.3% = 1.3% RealYield for US05Y
US07Y: 3.6% - 2.4% = 1.2% RealYield for US07Y
US10Y: 3.4% - 2.2% = 1.2% RealYield for US10Y
Note
Part 2: 
Note
Unemployment now at 3.4%!!
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