Recently, the interest rates of 2-year and 10-year US bond have narrowed significantly (2.33% vs. 2.37%), which is only one step away from the inverted (~4bp). Previously, this part of the curve has been inverted in 3 to 10 years (Figure 1~2). For a time, concerns arise in the US recession. The reason why the market is concerned is that the inverted yield curve is usually regarded as a proven leading indicator of recession, and naturally it will be regarded as a leading signal for US stocks . But is the inverted verbal so effective in judging recession as common sense thinks? What indicators should I pay attention to? What are the economic, policy and asset responses after the upside down in history? Is there any difference this time? We need to find out.
Chart 1: Since the beginning of the year, due to the expectation of monetary policy tightening, short-term interest rates have risen rapidly. Currently, 2s10s are only 4bp, 5s10s have been inverted
Source: Bloomberg, CICC Research Department
Chart 2: Before the March FOMC meeting, 2s10s were only 25bp, which is the narrowest before the interest rate hike cycle since 1990
Source: Bloomberg, CICC Research Department
Q1, what is the inverted hang? The short-end is higher than the long-end; the end of the flat curve is "upside down"
The so-called "upside down", that is, the short-end interest rate level is higher than the long-end, so that the overall treasury bond interest rate curve shows a pattern of high at the beginning and low at the end. Generally, long-term bond yields will be higher than short-term interest rates due to factors such as higher long-term returns (real interest rates), longer holding duration requires more compensation (period premium). But if the short-term end is higher, it means that the long-term return rate (expected) decreases, and the short-term financing cost is higher, which in turn will erode long-term growth expectations. After a period of time, it will put downward pressure on the economy and even enter a recession (Figure 3).
Chart 3: Looking at the yield curve (1s10s) inverted and economic recession (since 1940)
Source: Bloomberg, GFD, Haver, CICC Research Department
Judging from the changing patterns of the curve, the end of the flat curve is "inverted". generally speaking, flattening is Xiongping and Niuping. The former is faster on the short end than on the long end, which usually occurs in the early and mid-terms of rate hikes in (but it also occurred during the 2008 financial crisis). Xiong Ping's main logic is to directly affect the short-term financing cost through the interest rate corridor (overnight reverse repurchase and excess reserve ratio), and then conduct the short-term and long layer by layer along the interest rate curve (Figure 4). Therefore, the shorter the end is, the more affected by liquidity and policies, and the longer the end is, the more affected by fundamentals, inflation and risk premium . Niu Ping is faster than shorter than shorter, and most of it occurs during economic slowdowns. On the contrary, steepening is also divided into two types: bear steep and bull steep, so I won’t go into details. is currently in the overall stage of (Figure 5~6).
Chart 4: Central Bank Interest rate policy (such as interest rate hikes) mainly follows the interest rate curve from short to long layers. The shorter the end, the more affected liquidity and policies, the longer the end, the more affected the fundamentals, inflation and risk premium
Source: Federal Reserve, CICC Research Department
Chart 5: Xiongping usually occurs in the early and medium term of interest rate hikes, and Niuping usually issues Born during the economic slowdown
Source: Bloomberg, CICC Research Department
Chart 6: Economic and monetary policy background of narrowing interest rate spread
Source: Bloomberg, Haver, CICC Research Department
Q2. How to observe? 3m10s and 2s10s; 3m10s are relatively more accurate and close to
The entire US Treasury interest rate curve ranges from 1 month to 30-year term. The two interest rate spreads that are more concerned by the market are the two interest rates of 2 years and 10 years (2s10s), and 3 months and 10 years (3m10s). The 10-year Treasury bond interest rate is the medium- and long-term risk-free benchmark interest rate. Needless to say, the 2-year and 3-month interest rates usually overlap more with the Federal Reserve policy benchmark interest rate. 3m10s is closer in terms of judging the accuracy of the economic recession, which is one of the reasons why the Fed is paying more attention to the latter.Under normal circumstances, the trends of 2s10s and 3m10s are not much different, so they can be used alternately to prove each other, but this time is an exception. The trends of the two are very different (Figure 7). The benchmark interest rate rate started in March has just risen to 0.25~0.5%, and the 3m interest rate is basically normal (0.55%), but the two-year interest rate has risen to 2.28%, which is far higher than the normal level. The last time a similar situation occurred was dated back to 1994 (the interest rate was 100bp different from the federal funds rate in the first two years of interest rate hikes in 1994. The gap between the two years and the benchmark interest rate expanded to 175bp after entering the continuous interest rate hikes of 50bp, and the maturity spread continued to narrow, charts 8~9). Chart 7: From the perspective of judging the accuracy of the economic recession, 3m10s is closer, which is also one of the reasons why the Fed pays more attention to the latter; under normal circumstances, the trends of 2s10s and 3m10s are not much different, so they can be used alternately to prove each other, but this time is an exception. The two are very different
Source: Bloomberg, China Securities Research Department
Chart 8: The difference between the US Treasury interest rate and the federal funds rate in the first two years of interest rate hike in 1994 was 100bp. , During the continuous 50bp rate hike, the gap rose to around 175bp
Source: Bloomberg, CICC Research Department
Chart 9: The interest rate spread in the interest rate hike stage continued to narrow, especially after October; at the end of 1994, it was close to the inversion, basically corresponding to the end of the interest rate hike cycle
Source: Bloomberg, CICC Research Department
Q3, from inverted to recession? Looking closer and going far; there is an inverted silence before the recession, and there may not be a recession after the recession
The change in interest rates and curves itself is the result of policies and fundamentals rather than causes. Therefore, is overly and only relies on the curve as an indicator to judge the economic situation, which may be suspected of putting the cart before the horse and seeking a sword. Of course, this does not mean that the change in the curve is not important, after all, it is a key representation of market transactions and sentiment.
Looking back at history, since 1980, putting aside the violent fluctuation stage of interest rate levels in the stagflation environment in the 1980s, 2s10s have been inverted five times (December 1988~March 1990, May 1998, February 2000, December 2005- June 2007 , August 2019). According to NBER (National Bureau of Economic Research) classification of the US economic cycle, experienced an economic recession four times after the above five inversions, but the average interval is as high as 17 months and the difference is very large. (The shortest is 7 months in 2019 and the longest is as long as 26 months in 2005). After further investigation, we can find that in some cases, did not experience recession after inversion, or recession had nothing to do with inversion itself, such as 1998 (Asian Financial Crisis) and 2019. The closest inversion to us was from August to September 2019, and the 2s10s inversion was only 8 days. The subsequent economic recession in March 2020 was the result of the outbreak of the epidemic and cannot be blamed on the curve. Therefore, since the 1980s, the hit rate of inverted recession is 60% (3 out of 5 times), and is more accurate in its statement that there are inverted recessions before recession, but there may not be recession after recession.
The 3m10s mentioned above are more appropriate and accurate, and can be seen in history. Since the 1980s, 2s10s and 3m10s are both confirmed by each other, but 3m10s are usually closer to recession (2 months later). In other words, it is more than enough to judge the recession time when is inverted to 3m10s, not to mention the deviation between the two this time.
Considering that the 2s10s and 3m10s are too different this time, we have further sought more indicators for cross-proof, such as the actual interest rate. Take 2s10s as an example. Under normal circumstances, the actual interest rate of 2s10s is consistent with the nominal interest rate curve trend but has greater fluctuations. Due to data availability, the real interest rate of 2s10s has also been inverted and earlier than the nominal interest rate of 2s10s (about 1 to 2 months ahead). is different this time. Although the nominal interest rate of 2s10s is approaching the inverted, the real interest rate spread of 2s10s is still as high as ~180bp, which is the high since 2013, similar to the information conveyed by 3m10s. Not only that, the same is true for the risk neutral rate of the New York Fed model. Therefore, it can be seen that the accuracy of cross-proof of various indicators is higher, especially when there are obvious differences in each indicator (Figure 10).
Chart 10: When judging recession as a leading indicator, 3m10s is usually closer to recession (2 months later); the real interest rate of 2s10s is also inverted and earlier than the nominal interest rate of 2s10s (about 1 to 2 months ahead); not only that, the risk neutral rate of the New York Fed model is also the same
Source: Bloomberg, CICC Research Department
Q4. How to react after inverted? The market continues to rise, but the valuation shrinks; the curve is inverted in the later stage and is a large amount of stocks and bonds; the initial stage is financial cycle , and the later stage technology leads
► After the inverted, the stock market continues to rise (the average increase 0%), an average of 10.5 months away from the turning point. Since has a long interval of recession from the inverted distance, it is not a good basis for judging the stock market. As the yield curve continues to flatten or even reverse, the US stock market did not immediately turn down. From historical experience, since the 1980s, after the inversion of economic recession (December 1998, February 2000, December 2005, and August 2019), the US stock market continued to rise, with an average of 10.5 months (10 months, 7 months, 19 months and 6 months) from the turning point. The S&P 500 index rose by 31%, 8%, 24%, and 18%, with an average increase of 20%. is therefore not a more effective turning point signal in terms of increase or time (Figure 11).
Chart 11: Looking back on historical experience, the stock market continued to rise after the inversion (average increase of 20%), 10.5 months from the turning point,
Source: Bloomberg, CICC Research Department
► Valuation usually shrinks or remains flat. The market was able to maintain its upward trend mainly due to profit support, but the valuation was shrinking or basically flat during this period. The reason is mainly because it is difficult for market valuations to expand significantly again in the context of the overall interest rate center moving upward, especially the rapid rise in short-term interest rates (Figure 12).
Chart 12: Valuation inflation shrinks or remains flat in the inverted stage of the yield curve
Source: Bloomberg, CICC Research Department
► Volatility usually rises. VIX has no direct significant relationship with curve changes, but when the curve is inverted, it often corresponds to the rise of VIX index and the fluctuations increase (Figure 13).
Chart 13: When the yield curve is inverted, it often corresponds to the rise of the VIX index
Source: Bloomberg, CICC Research Department
► The relationship between style and curve changes is not stable. compared the yield curve with value/growth style rotation. We found that the two were positively correlated in the 1990s to the technology bubble; before the financial crisis from 2003 to 2008, the two were negatively correlated; after 2009, it turned positively correlated again until the reversal in November 2022 (Figure 14).
Chart 14: The relationship between the relative performance of the US stock market style and the yield curve is not stable
Source: Bloomberg, CICC Research Department
Specifically for the sector, after the inverted period, the initial cycle and finance are leading, the medium-term daily consumption/defense performance is good, and the later technology sector is the best. According to the experience of five upside-downs since 1980, on average, within 3 months after the upside-down, upstream cyclical sectors such as raw materials, capital products, petroleum, gas and coal, as well as financial services, insurance, real estate and other sectors were leading; within 3-6 months, daily consumption/defense sectors such as food and beverage, household daily necessities, and utilities began to catch up, and finance still performed well; but after half a year and one year, technology was leading, finance and cycles were lagging behind (Figure 19). This also fits the law that the longer the time, the greater the risk of recession.
Chart 19: The performance of the US stock industry during the previous yield curve (2s10s) inversion since 1980 (2s10s) (performance in each stage median )
Source: Datastream, CICC Research Department
► Cross-market and assets, the relative strength of development and emerging does not entirely depend on the curve pattern. is that the US bond curve only represents the fundamentals of the United States.Comparing the performance of developed MSCI and emerging markets, the US bond curve is positively correlated with developed/emerging before the 2008 financial crisis (i.e., the curve is flat and developed underperformed); it is negatively correlated after the financial crisis to 2015; it is positively correlated again from 2016 to 2020; it is negatively correlated since the epidemic (Figure 15). In addition, the curve changes are also not necessarily related to the gold and dollar index (Figures 16~17).
Chart 15: The relative strength of development and emerging is not entirely dependent on the curve pattern
Source: Bloomberg, CICC Research Department
Chart 16: Changes in the yield curve have no obvious direct impact on gold prices.
Source: Bloomberg, CICC Research Department
Chart 17: Changes in the yield curve have no significant direct impact on the US dollar index
Source: Bloomberg, CICC Research Department
However, overall, after the curve is inverted, the order of major assets is stock bulk bonds, and the later stage, the ordering is gradually switched to stock bonds (Figure 18).
Chart 18: All yield curves (2s10s) inverted periods (median performance in each stage)
Source: Bloomberg, Factset, CICC Research Department
Q5, the impact of inverted policy? After the inverted Fed often ends the interest rate hike cycle or cuts interest rates
After the previous "real" inverted (both 3m10s and 2s10s are inverted), most of the Fed will stop raising interest rates and even enter a cycle of interest rate cuts. Taking 2s10s as an example, after the inverted in December 1988, the Federal Reserve raised interest rates for the last time in February 1989 and began to cut interest rates in the same month (the interest rate cut was 2 months away from the inverted interest rate); after the inverted in May 1998, the Federal Reserve began to cut interest rates in September 1998 (4 months away from the inverted interest rate); after the inverted in February 2000, the Federal Reserve raised interest rates for the last time in May 2000 and began to cut interest rates in January 2001 (13 months away from the inverted interest rate); after the inverted in December 2005, the Federal Reserve raised interest rates for the last time in May 2006 and began to cut interest rates in June 2006 (6 months away from the inverted interest rate); after the inverted in August 2019, the Federal Reserve was in the preventive interest rate cut stage (three cuts from July to September). If it were not for the outbreak of the epidemic, there might not be a recession. Overall, after the 2s and 10s inverted, the Federal Reserve entered a period of at least 2 months (1989) and a maximum of 13 months (2000).
Chart 20: The economic situation and market performance of the yield curve inverted since 1978
Source: Bloomberg, CICC Research Department
Q6. What is the difference this time? 2s10s are currently distorted, which is obviously different from other indicators, so it may not be used as an effective indicator for judging recession. Compared with historical experience, the difference this time is in several points: 1) just raised interest rates in 2s10s, and the last type of situation is traced back to the 1999 interest rate hike cycle (the 2s10s spread was only 25bp before interest rate hikes started in June 1999); 2) 2s10s are approaching inverted, and the 3m10s are still very different; 3) 2s10s is approaching inverted interest rates, but the real interest rate in 2s10s is still expanding, and the neutral interest rate in 2s10s is not inverted and the relative interest rate is higher. In short, there is a clear deviation between the various indicators.The reason is mainly because the inflation expectation included in the 2-year treasury bonds once reached a historical high of more than 5%, which is very rare, far higher than the 10-year inflation expectation level of 2.86%, which overreacts the impact of the sharp rise in oil prices as the situation in Russia and Ukraine escalates (Figure 21~22). Therefore, we believe that 2s10s may be a bit distorted and cannot rely solely on this indicator to judge the decline. At least we need to wait for the cashing of other indicators to verify.
Chart 21: Against the backdrop of the rapid rise in oil prices recently, the 2-year inflation expectations have risen rapidly, rising from 3.3% at the end of January to the current 4.6%
Source: Bloomberg, CICC Research Department
Chart 22: Compared with the 2-year period, the 10-year inflation rise is relatively moderate, resulting in a significant inversion of the 2s10s inflation expectations in the near future (~-175bp)
Source: Bloomberg, CICC Research Department
Q7, what are the factors that affect the next? Inflation path and balance sheet shrinking
Since the main reason for 2s10s is that the 2-year high is too high, especially the implicit inflation expectations in the 2-year period are too high, then after the inflation high point appears, the 2-year pressure will naturally gradually ease. The situation in Russia and Ukraine this time has played an unexpected supply shock in the crude oil market under the already tight supply balance. However, the existing import sanctions against Britain and the United States may be more difficult to become effective constraints, which is incomparable to the Iranian sanctions in 2014 and is also very different from the supply shortage in the 1970s. CICC's large commodity group expects oil prices to remain between US$100 and US$105 per barrel this year. In this case of , oil prices that surge but fall more often delay the arrival of inflation turning point. Unless they rise again, they will not change the direction of inflation falling in the second half of the year under the high base and the improvement of the epidemic. We estimate that if the oil price rises by $140 per barrel but remains around $100 later, the inflation decline trend remains unchanged, but the speed slows down. At the end of the year, CPI is roughly around ~5% year-on-year (Figure 23~24).
Chart 23: Therefore, as long as oil prices do not rise further, the direction of overall inflation decline in the second half of the year was not changed last year's high base and the epidemic improved
Source: Bloomberg, CICC Research Department
Chart 24: According to the calculations of the bulk group, under the benchmark situation, crude oil supply decreased by 1 million to 2 million barrels per day, and the price in 2022 is between 100 and 105 US dollars per barrel
Source: Bloomberg, CICC Research Department
In addition, the balance sheet reduction will be started in May, and there are also differences in the impact of the curve. Compared with the transmission path of interest rate hikes, the balance sheet reduction may have a greater impact on the long-end unless the Fed's balance sheet reduction operations focus more on short-end interest rates. At the March FOMC meeting, the Federal Reserve hinted that it may start a balance sheet reduction in May. We estimate that the rate of balance sheet reduction may reach up to US$90 billion to US$100 billion per month ("March FOMC: Rate hikes are implemented, Balance Sheets are clear"). The Federal Reserve directly holds a considerable scale of long-term Treasury bonds (about 42% of the 5-10-year and above). Considering the current constraints of the 2s-10s approaching inversion, we believe that the Federal Reserve does not rule out the implementation of "implicit yield curve control" by balancing the maturity scale during specific balance sheet reduction operations, that is, pushing more long-term pressure to alleviate the inverted pressure (Figure 25-26).
Chart 25: Currently, the Federal Reserve holds long-term (5-10-year and above) Treasury bond scale accounts for 42%, and this proportion was 60% before the balance sheet reduction in 2017
Source: Bloomberg, CICC Research Department
Chart 26: The Federal Reserve hinted that it may start balance sheet reduction in May. We estimate that the rate of balance sheet reduction may reach up to US$90-100 billion per month
Source: Bloomberg, CICC Research Department
Q8. From a fundamental perspective, how far is the United States from the recession? Slowing down gradually, but the recession may still be far from
The slowdown in the US economy is an inevitable trend. First, the base of 2021 is too high, and second, more stimulus will occur in 2021, so it is unrealistic to expect accelerated economic growth in 2022. However, slowing down does not mean recession. The slow variable that declines after a long time is also completely different from the impact of the rapid and stormy acute diseases on the market.
From a fundamental perspective, the United States is currently in the early stage of slowing down, and the growth high has passed. The recovery of the epidemic may have a certain good impact in the second quarter, but the overall healthier leverage levels in various departments make it difficult for us to find a reason for recession similar to the balance sheet and leverage breakdown. Judging from economic data, according to the unanimous expectations of Bloomberg , the year-on-year growth rate of GDP may still remain above 3% in 2022. Although it is lower than 5.7% in 2021, it is also higher than the average growth rate of 2% before the epidemic.In addition, the recovery of the epidemic and economic opening have sent good signals at the employment level. The labor participation rate of the elderly (over 65 years old) in February has also rebounded again, and the overall unemployment rate in the United States has dropped to a low level of 3.8%. In addition, the excess savings of US residents of US$2.5 trillion and the leverage ratio of 77% of enterprises (75% before the epidemic) also provide support for subsequent consumption and investment (Figure 27~30).
Chart 27: According to Bloomberg's unanimous expectations, the year-on-year GDP growth rate may still remain above 3% in 2022
Source: Bloomberg, CICC Research Department
Chart 28: The epidemic recovery and economic opening have released good signals at the employment level
Source: Bloomberg, CICC Research Department
Chart 29: American residents still have US$2.5 trillion in excess savings, providing support for consumption
Source: Bloomberg, CICC Research Department
Chart 29: US residents still have US$2.5 trillion in excess savings, providing support for consumption
Source: Bloomberg, CICC Research Department
Chart 29: US residents still have US$2.5 trillion in excess savings, providing support for consumption
Source: Blo omberg, CICC Research Department
Chart 30: The leverage level of the enterprise end is not good, which also means that if you are willing, you can have investment capabilities
Source: Bloomberg, CICC Research Department
Looking forward, the downside risk is a sharp increase in supply risk that forces the Federal Reserve to be unable to take into account growth and cannot raise interest rates more severely, which ultimately leads to a significant suppression of demand; the upside risk is a breakthrough of the new growth momentum centered on the US government's leverage transformation into residents' consumption, such as US corporate capital expenditure (Where has the capital expenditure cycle gone? Investment cycle for overseas asset allocation (3)), or China's new round of stimulus boosts demand and partially spilled out to the United States.
Article source
This article is excerpted from: "U.S. Treasury yield curve inverted eight questions and eight answers" published on March 31, 2022
Liu Gang, CFA SAC Certification number: S0080512030003 SFC CE Ref: AVH867
Li Hemin SAC Certification number: S0080120090056 SFC CE Ref: BQG067
Li Yujie SAC Certification number: S0080121040091 SFC CE Ref: BRG962
Wang Hanfeng SAC Certification number: S0080513080002 SFC CE Ref: AND454
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