By Peter Sheahan, Director – Money Markets, Curve Securities
In the pre-Covid era, inverted yield curves were highly predictive of an eventual recession. This is not proving to be the case post-Covid. Inverted yield curves no longer slow the economy as effectively as they used to.
The yield curve has been inverted since July 2022. In December 2022, most strategists were calling a recession. Fast forward a year to December 2023, the market is telling us an inverted curve is no longer required. Uncertainty lies squarely on whether the FED is going to hike again.
But the long end is rallying and refusing to twist or pivot to reflect a positive slope. Why?
The disinflationary forces are reacting faster than most people expect. The market is betting the FED is going to uninvert the yield curve. Historically, FED cuts are usually six to 12 months after the last hike. 1Q2024 is nine months after July 2023. So, is the FED meeting on 31 March 2023 a realistic timeframe?
We have just experienced the fastest decline in inflation since WWII. On what basis should financial conditions remain tight if inflation is moderating? If inflation reaches 2.5%, then the FED has no reason to maintain tight financial conditions.
Also read: The Non-Bank Edge Driving Strong Outcomes
Money market funds drain like a sink hole when the curve is going to uninvert. The record amount of “risk off” cash sitting on the sidelines patiently waiting in the eye of the storm for the catastrophic recession is now on the move. November record flows into riskier assets demonstrates this.
Uninverting can happen by long rates rising above the elevated level of short rates or short rates rallying to trade under the elevated levels of long rates. Each of these scenarios could be premised under adverse economic circumstances of aggressive inflation or a deterioration of economic activity, generally referenced as a hard landing.
The current momentum is made up of an entirely different set of drivers. The extraordinary level of “risk off” cash built up under the expectation an inverted curve was going to drive a recession “right up to the front door” has just not been delivered. The capitulation during November 2023 is stark. The US government and FED have co-ordinated to divert the record US$2.55 trillion of funds sitting at the FED in the reverse repo facility across to high yielding US Treasury Bills for a yield pickup. Twelve months on, only US$823 billion remains and will probably deplete to zero which was the level when the facility was created in 2Q2021. US Authorities just don’t want so much money sitting in money market funds.
The analogy of a truck moving across to the right lane to pass another truck comes to mind. If the truck in the left lane speeds up then the intention of the passing manoeuvre is thwarted, frustration builds, and a new strategy unfolds. Uninverting the US yield curve may prove to be similarly problematic. Instead of remaining steady at elevated yields, US 10yr Treasuries have accelerated down in yield, faster than US 2 yr rates. The spread has widened in the move commenced around 9 November 2023 to the current minus 49 bpts.
The strategy to uninvert the US yield curve may be vastly different this time and not a “textbook” play. This is going to be a topic of discussion with so many opinions on which flight path the FED will log into the system.
