"The Warning of the 'Adjusted' Yield Curve"
by Brian Maher
"Yesterday we furrowed our brow against the latest inversion of the “yield curve.” The 10-year Treasury yield has slipped beneath the 3-month Treasury yield — to its deepest point since the financial crisis, in fact. Inverted yield curves precede recessions nearly as reliably as days precede nights, horses precede carts… lies precede elections. The 10-year Treasury yield has dropped beneath the 3-month Treasury yield on six occasions spanning 50 years. Recession was the invariable consequence — a perfect 1,000% batter’s average.
But an inverted yield curve is no immediate menace. It may invert one year or more before uncaging its furies. But today we revise our initial projections — as we account for the “adjusted” yield curve.
The “adjusted” yield curve indicates recession may be far closer to hand than we suggested yesterday. When then might you expect the blow to land? Now… you realize we cannot spill the jar of jelly beans straight away. You must first suffer through today’s market update...
Markets plugged the leaking today. The Dow Jones gained 43 points on the day. The S&P scratched out six. The Nasdaq, meantime, added 20 points. Gold — safe haven gold — gained nearly $7 today. But to return to the “adjusted” yield curve… and the onset of the next recession.
The Nominal vs. the Real: We must first recognize the contrast between the nominal and the real. The world of appearance, that is — and the deeper reality within. For example… nominal interest rates may differ substantially from real interest rates. Nominal rates do not account for inflation. Real interest rates (the nominal rate minus inflation) do.
That is why a nominal rate near zero may in fact exceed a nominal rate of 12.5%... Nominal interest rates averaged 12.5% in 1979. Yet inflation ran to 13.3%. To arrive at the real interest rate…
We take 1979’s average nominal interest rate (12.5%) and subtract the inflation rate (13.3%). We then come to the arresting conclusion that the real interest rate was not 12.5%… but negative 0.8% (12.5 – 13.3 = -0.8).
Today’s nominal rate is between 2.25% and 2.50%. Meantime, (official) consumer price inflation goes at about 2%. Thus we find that today’s real interest rate lies somewhere between 0.25% and 0.50%. That is, despite today’s vastly lower nominal rate (12.5% versus 2.50%)… today’s real interest rate is actually higher than 1979’s negative 0.8%.
The Standard Yield Curve vs. The “Adjusted” Yield Curve: After this fashion, the standard yield curve may differ substantially from the “adjusted” yield curve. Michael Wilson is chief investment officer for Morgan Stanley. He has applied a similar treatment to distinguish the adjusted yield curve from the standard yield curve. The standard yield curve — Wilson insists — does not take in enough territory. It fails to account for the effects of quantitative easing (QE) and subsequent quantitative tightening (QT).
The adjusted yield curve does. It reveals that QE loosened financial conditions far more than standard models indicated. It further reveals that QT tightened conditions vastly more than officially recognized.
The adjusted curve takes aboard the Federal Reserve’s estimate that every $200 billion of QT equals an additional rate hike… for example. The standard yield curve does not. Thus the adjusted yield curve reveals a sharply more negative yield curve than the standard.
Here, in graphic detail, the adjusted yield curve plotted against the standard yield curve:
The lighter line represents the standard 10-year/3-month yield curve. The red line represents the adjusted yield curve — that is, adjusted for QE and QT. The adjusted yield curve rose steepest in 2013, when QE was in full roar. But then it began a flattening process...
QT Drastically Flattened the Adjusted Curve: The Federal Reserve announced the end of quantitative easing in late 2014. And Ms. Yellen began jawboning rates higher with “forward guidance” — insinuating that higher rates were on the way in 2015. Thus financial conditions began to bite… and the adjusted yield curve began to even out. By the time QT was in full swing, the adjusted curve flattened drastically. The standard curve — which failed to account for QT’s constraining effects — did not match its intensity.
Explains Zero Hedge: "The adjusted curve shows record steepness in 2013 as the QE program peaked, which makes sense as it took record monetary support to get the economy going again after the great recession. The amount of flattening thereafter is commensurate with a significant amount of monetary tightening that is perhaps underappreciated by the average investor."
Now our tale acquires pace — and mercifully — its point.
The Adjusted Yield Curve Inverted Long Before the Standard: After years of flattening out, the standard yield curve finally inverted in March. Prior to March, it last inverted since 2007 — when it presented an omen of crisis. But since March, the standard curve bounced in and out of negative territory. The recession warning it flashed was therefore dimmed and faint — until veering steeply negative this week.
But the adjusted yield curve did not invert in March... It inverted last November — four months prior. And it has remained negative to this day. Wilson: "Adjusting the yield curve for QE and QT shows an inversion began at the end of last year and persisted ever since."
Thus it gives no false or fleeting alarm — as the standard March inversion may have represented. We refer you once again to the above chart. Note how deeply the adjusted yield curve runs beneath the standard curve.
A “Far More Immediate Menace”: Meantime, evidence reveals recession ensues 311 days — on average — after the 3-month/10-year yield curve inverts. But if the adjusted curve inverted last November… we are presented with a far more immediate menace.
Here Wilson sharpens the business to a painful point, sharp as any thorn: "Economic risk is greater than most investors may think... The adjusted yield curve inverted last November and has remained in negative territory ever since, surpassing the minimum time required for a valid meaningful economic slowdown signal. It also suggests the “shot clock” started six months ago, putting us “in the zone” for a recession watch."
If recession commences 311 days after the curve inverts — on average — some 180 days have already lapsed. And so the countdown calendar must be rolled forward. Perhaps four–five months remain… until the fearful threshold is crossed. If the present expansion can peg along until July, it will become the longest expansion on record. But if the adjusted yield curve tells an accurate tale, celebration will be brief..."