Just when you might have thought that financial markets could not turn any funkier — they have. On Tuesday, Jay Powell, US Federal Reserve chair, indicated that the Fed may raise rates further than expected in order to combat inflation.
Two-year Treasury yields duly jumped above 5 per cent for the first time since 2007. But 10-year yields barely moved. This pushed the yield curve deeper into an Alice-in-Wonderland state known as “inversion”, in which it costs more to borrow money short term than long term. By Wednesday, the gap had expanded to a negative 107 basis points — an extreme pattern only seen once before, in 1980 — when Paul Volcker, then Fed chair, was unleashing shock therapy.
What has sparked this pattern? One explanation is that bond investors think Powell will follow in Volcker’s footsteps and unleash a deep recession. After all, historical models show that “every recession since the mid-1950s was preceded by an inversion of the yield curve”, as economists at the San Francisco Fed recently noted. They added that “there was only one yield curve inversion in the mid-1960s that was not followed by a recession within two years”.
Or as Anu Gaggar, analyst at US advisory firm Commonwealth, observed last year: “There have been 28 instances since 1900 where the yield curve has inverted; in 22 of these episodes, a recession has followed.”
But there is precious little evidence of this as yet. Yes, there are hints of rising consumer stress. But as Powell noted this week, the labour market is red hot, and when I met business leaders in Washington last week, the mood was strikingly bullish.
So is there something happening that might cause the inversion pattern to lose its signalling power? We will not know for several months. But there are two key factors that investors (and the Fed) need to watch: speculative positioning and generational cognitive bias.
The first issue revolves around some important data from the Commodity Futures Trading Commission. Normally, the CFTC reveals each week whether speculative investors, such as hedge funds, are “long” or “short” interest rate futures (ie whether they are collectively betting that rates will fall or rise, respectively).
But in a ghastly, and ill-timed, twist, the CFTC has recently failed to issue this data on time due to a cyber hack. We do know, though, that in early February hedge funds had a record high “short” against two-year Treasuries, ie a massive bet that rates would rise.
Without the CFTC data, we do not know what has happened since. However, regulators tell me they think there is now significant positioning by funds in Treasuries, echoing patterns seen in early 2020. If so, this might have exacerbated the inversion pattern (and could cause it to flip back in the future if positions are unwound).
The second issue — that of generational cognitive bias — revolves around investors’ concept of what is “normal”. One interpretation of the inversion pattern is that investors expect the financial ecosystem to return to the pre-Covid pattern of ultra-low rates after Powell has curbed the Covid-linked wave of inflation.
Some economists think this is a reasonable bet. This week, for example, a fascinating debate occurred at the Peterson Institute between economic luminaries Olivier Blanchard and Larry Summers. In it, Blanchard argued that we would soon return to a world where “neutral” interest rates (or a level that does not cause inflation or recession) were very low — implying that the current inversion pattern makes perfect sense.
However, others believe it is a mistake to think we will return to the pre-Covid world of low long-term rates since there are bigger structural shifts in the global economy. “Some of what’s making the neutral rate be higher may be temporary, but there’s no reason to think that all of it is temporary,” Summers argued.
Macroeconomic shifts aside, there is another, often-overlooked cultural issue as well: the propensity for people to define “normality” as what they grew up with. Most notably, financiers under the age of 50 built their careers in a world of ultra-low rates and inflation. They therefore tend to view this as “normal” (unlike the Volcker era, when double-digit inflation and interest rates were the “norm”).
But that could be creating biases, causing the market to underestimate long-term rates, as Goldman Sachs has pointed out. “Investors appear to be wedded to the secular stagnation . . . view of the world from the last cycle,” it argues. “[But] we believe this cycle is different,” it adds, arguing that a recession seems unlikely, ie that the signals from the inversion pattern are wrong.
Of course, history shows that when investors start invoking the phrase “this time is different”, they are also often completely wrong. Just look at the work that the economists Carmen Reinhart and Kenneth Rogoff have done on this for evidence.
But as the Fed — and markets — grapple with a financial wonderland, the key point is this: while an economic slowdown may very well loom, it would be foolish to look at macroeconomics alone to make sense of market signals. Now, more than ever, investors need to ponder their own biases about “normality”. And pray that the CFTC manages to release its crucial positioning data soon.