More on the steepening yield curve and deteriorating credit conditions

I want to talk a little about price action in asset markets this week. But, since I am on holiday, I am going to keep this short. Most of the focus has been on equities, where volatility has increased. But I am looking at this as more of a rotation from an under-weight Treasuries position than one of impending recession or financial crisis.

Focus on Treasuries

I wrote a markets piece a couple of days ago on this topic. Sign up for those tiers is here. But let me expand on that with the price action from today. What’s interesting is how we are seeing two cross currents simultaneously.

First, there’s the continued steepening of the US Treasury yield curve, which is generally bullish. When I wrote about this on Wednesday I said “the 2- to 10-year spread is back to over 18 basis points from as low as 10 basis points.” But, Treasuries closed the day with an even wider differential, with 10-year paper at 2.716%, almost 20 basis points wide of 2-year yields at 2.518%. So the yield curve is definitely steepening. If you’re looking for signals of impending recession, you’re not getting it from this metric.

Yet, when you look at the middle of the curve we see something bearish reasserting itself. In Wednesday’s market piece, I wrote that “the 1-year to 3-year section of the curve is still inverted with 1-year paper trading at 2.613%, while 2-year paper is at 2.611% and 3-year Treasuries yield 2.603%. But the 5-year sold off steeply today such that the 1- to 5-year inversion has now flipped to 5 basis points of steepness.”

Today, the 1-year to 3-year section of the curve is still inverted. But the one-year is also now yielding more than the 5-year again. The rates are 2.591% for 1-year, 2.518% for 2-year, 2.498% for 3-year and 2.555% for 5-year paper.

So while the curve may be steepening, the middle of the curve inversion has reasserted itself. That’s a clear sign the market expects a pause and, eventually a reversal in, say, the next 12-24 months.

My view: it’s the credit cycle, stupid

At this point in the cycle, it’s all about credit. I think University of Chicago Professor Amir Sufi gets it right when he tweets:

The paper he points to has this as an abstract. I have bolded the part that I think is most important:

Using micro-level data, we construct a credit spread index with considerable predictive power for future economic activity. We decompose the credit spread into a component that captures firm-specific information on expected defaults and a residual component—the excess bond premium. Shocks to the excess bond premium that are orthogonal to the current state of the economy lead to declines in economic activity and asset prices. An increase in the excess bond premium appears to reflect a reduction in the risk-bearing capacity of the financial sector, which induces a contraction in the supply of credit and a deterioration in macroeconomic conditions.

Powell, as a private equity guy, is probably attuned to this. And I suspect, if the spike in yield spreads stays large, the Fed will remain on hold, perhaps indefinitely. Meanwhile, we are in month 115 of the economic expansion. We need to get through another six months to get to a record. I think we’ll make it.

How much further we get depends on how much the real economy slows, how quickly the incipient credit slowdown advances, and how the Fed reacts to this course of events. Fiscal policy is off the table. Trillion dollar deficits and Nancy Pelosi’s advocacy of PAYGO make that a political certainty.

Have a good weekend.

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