The Big Idea
Reading inflation and recession in the yield curve
Steven Abrahams | October 29, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Yields on the front end of the US yield curve have moved up quickly in October with a much more muted response in longer rates. The market is repricing the path of inflation, the Fed response and the ultimate impact of both on the economy and growth. The market still sees inflation as transitory, but it is worried that the Fed medicine needed to cure it will tip the patient into recession.
The market is clearly worried about inflation in the short run but not in the long run. And that has been true since the start of the year, when implied 2-year inflation moved above implied 5-year 5-year inflation—the 5-year inflation rate starting five years from now—the market’s best estimate of inflation in the long run. We have had an inverted implied inflation curve ever since, and the inversion has become even more extreme in October. Implied 2-year inflation has moved from around 250 bp at the start of the month to around 300 bp at the end while 5-year 5-year inflation has barely budged (Exhibit 1).
Exhibit 1: The inversion in the implied inflation curve has become more extreme
The short end of the inflation curve clearly reflects the labor shortages and supply chain problems and the broadening of price pressures beyond the pandemic categories that led inflation in the spring, but the long end of the curve does not see those pressures persisting. You can assume prices will decelerate naturally in the long run, that new sources of supply or substitutes will come out in response to higher prices and that labor will come off the sidelines in response to higher wages. But a simpler and possibly more practical assumption is that the Fed will solve the inflation problem if the economy does not solve it on its own. In other words, the Fed has credible tools for driving inflation down to target, and it will use them: rate hikes.
The problem with rate hikes is that they have contributed to US recessions on more than one occasion. The hikes required in the early 1980s to tame inflation tipped the US into recession in 1980 and again in 1981 and 1982. Hikes in the late 1980s along with a 1990 oil price shock and other factors led to recession in 1990 and 1991. Modest hikes into 2000 and the bursting of the Internet bubble preceded a brief recession in 2001. And hikes in the 2000s preceded the Great Recession of 2007 through 2009, although hikes in that case may have played only a bit part.
If the inflation markets in the worst case see the Fed as willing and able to hammer inflation down, the rates markets also see the risk of recession and a return to slow growth. Since the start of October, the US 2-year yield has moved up 22 bp, the 5-year up 21 bp, the 10-year up 6 bp and the 30-year down 12 bp. The short end of the curve has repriced to inflation. The long end has become an option on aggressive Fed hiking with recession in its wake.
It is also worth noting that the pessimism of the long end of the curve also shows up in forward rates. Most of the movement in forwards comes in the 5-year and shorter part of the rates curve while 10-year forwards move higher modestly and 30-year forward barely at all (Exhibit 2). And to connect the dots between forward inflation and forward rates, today’s implied 5Y5Y inflation rate of 225 bp stands higher than the 5-year forward 5-year nominal rate of 199 bp. In other words, the markets assume that five years from now, growth will still be insufficient to soak up the available pools of liquidity and the US will still have negative real rates.
Exhibit 2: Forward rates imply most of the action in the front of the curve
Belief in transitory inflation and concern about ultimate growth have persisted in the rates market since early in the year, and that has not changed. The presumable launch of Fed taper in the coming week begins a slow roll towards Fed hikes. If all goes well, the cycle ends with the economy at equilibrium growth. But history and the rates markets say there is recession risk, and an option on it is for sale in the long end of the yield curve.
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The view in rates
The Fed RRP continues to soak up a healthy amount of system liquidity. After peaking at $1.6 trillion on September 30, it is closing Friday at $1.5 trillion. A lack of T-bills is making it hard for money market funds to find places to invest, so RRP keeps getting the business.
Settings on 3-month LIBOR have closed Friday at 13.163 bp, at the high end of the recent range. LIBOR clearly is trading with an eye on transition to other benchmarks by June 30, 2023. All interdealer swap trades have moved to SOFR effective October 22, with dealers, banks and others urged to create no new LIBOR exposures after December 31 this year.
The 10-year note has finished the most recent session at 1.55%, down 8 bp from a week ago. Weak third quarter GDP has contributed to the little rally. Breakeven 10-year inflation is at 259 bp, down 5 bp in the last week. The 10-year real rate finished the week at negative 103 bp, down from negative 100 bp a week ago.
The Treasury yield curve has finished its most recent session with 2s10s at 106 bp, flatter by 12 bp on the week, and 5s30s at 75 bp, flatter by 12 bp on the week.
The view in spreads
The bullish case for credit and the bearish case for MBS continues. Corporate and structured credit has held spread through most of the year despite the steady approach of Fed tapering. MBS, on the other hand, generally widened from the end of May before starting to tighten after the September FOMC.
The difference is partly in the composition in demand across the sectors and in strong corporate fundamentals. The biggest buyers of credit include money managers, international investors and insurers while the only net buyers of MBS during pandemic have been the Fed and banks. Credit buyers continue to have investment demand. Demand from Fed and banks should soften as taper begins, Once the Fed shows it hand on the timing and pace of taper, the market should be able to fully price the softening in Fed and bank demand and spreads should stabilize. But something else is on the horizon.
MBS stands to face a fundamental challenge in the next few months as the market starts to price the impact of higher Fannie Mae and Freddie Mac loan limits. Home prices are tracking toward a nearly 20% year-over-year gain, which should get reflected in new agency loan limits traditionally announced in late November for loan delivered starting January 1. The jump in loans balances should add significant negative convexity to the TBA market and increase net supply. And this will come just as the Fed leans into tapering, which will take out a buyer that often absorbed the most negatively convex pools from TBA and a large share of net supply. The quality of TBA should deteriorate and the supply swell.
The view in credit
Credit fundamentals continue to look strong, although inflation could start to squeeze margins. Corporations have record earnings, good margins, low multiples of debt to gross profits, low debt service and good liquidity. The consumer balance sheet now shows some of the lowest debt service on record as a percentage of disposal income. That reflects both low rates and government support during pandemic. Rising home prices and rising stock prices have both added to consumer net worth, also now at a record although not equally distributed across households. Consumers are also liquid, with near record amounts of cash in the bank. Strong credit fundamentals may explain some of the relatively stable spreads.