When it comes to timing the next recession – or the next Fed policy mistake – there are few signals that pundits rely more on than the shape of the yield curve, which, as we have covered extensively in the past year, has bear flattened dramatically since 2015 as the Fed has hiked rates, with the 2s10s now just 50bps away from inverting at which point the countdownto both a recession and a bear market begins.
However, at a time of unprecedented central bank meddling and manipulation in all rates (and equity) markets, many believe that the longer-dated curve is no longer indicative of anything but noise, especially at a time when the long-end is directly being bought by central banks (or sold by Chinese reserve managers depending on how much Trump’s trade war escalates) thus distorting any “signal” value it may have. In its place, a more accurate “signal” has emerged in the short-end of the curve, as manifested by the Overnight Index Swap, or OIS, futures market.
And it is here that something very notable has just happened: as JPMorgan observes the forward curve for the 1-month US OIS rate, a proxy for the Fed policy rate, has inverted after the two-year forward point, to wit:
The US yield curve has started showing first signs of inversion. As shown in Figure 1 which depicts the forward curve for the 1-month OIS rate the US yield curve is currently slightly inverted after the two-year forward point.
Another way of visualizing the inversion is by charting the front end between the 2-year and 3-year forward points of the 1-month OIS. Here, as the next chart shows, a curve inversion arose for the first time during the first week of January, but it only lasted for two days at the time and the curve re-steepened significantly in the following weeks.
However, The US OIS curve started immediately flattening again after the February equity correction and the spread between the 2y and the 3y forward points of the US 1-month OIS rate curve entered negative territory last week on March 29th; the spread has been hovering between +1bp and -1bp since March 19th suggesting that the current episode of yield curve inversion is more persistent than the brief inversion seen during the first week of January.
All else equal, this would imply some expectation priced in of a reduction in the Fed policy rate after Q1 2020; that or the market starting to actually price in – and not just contemplating – the next Fed policy error, i.e., hiking right into the next recession.
This is a big deal: as JPM’s Nikolaos Panigirtzoglou writes, an inversion at the front end of the US curve is a significant market development, not least because it occurs rather rarely.
As shown in Figure 3, it happened only three times over the past two decades: in 2005, 2000 and 1998. What looked different during these three past episodes relative to today is that the US curve had also been inverted further to the front end, i.e. between the 1y to 2y forward points and not only between the 2y to 3y forward points. However Figure 3 suggests that the 2y-3y forward point spread has been generally leading the 1y-2y one, so it might be a matter of time until the latter turns negative also in the current conjuncture.
Not only that, but going back to our original observation about the shape of the 2s10s curve, JPM’s Panigirtzoglou also argues that “the more widely followed proxy of yield curve inversion, the 2s10s UST spread, has been also led in the past by the 2y-3y forward point spread as shown in Figure 4. Therefore it might also be a matter of time until the 2s10s UST curve inverts too, though there is little to suggest such an inversion is imminent.“
While redundant, JPM notes that “such inversion is also generally perceived as a bad omen for risky markets” and notes that two potential fundamental explanations stand out:
- markets have started pricing in a Fed policy mistake, or
- markets have started pricing in end-of-cycle dynamics.
How to distinguish between the two? Here the JPM strategist concedes that while such an exercise would be difficult, especially as a Fed policy mistake would naturally shorten the cycle, there should be some distinction in terms of investor flow patterns:
- 1) Pricing in a Fed policy mistake should induce investors to focus on earlier growth weakness and should therefore be accompanied by weak equity fund flows, weak cyclical sector flows, greater flows in long dated bond funds vs short dated ones and weak flows in interest rate sensitive sectors such as housing.
- 2) Pricing in end of cycle dynamics should be accompanied by overheating and inflation fears, i.e. greater flows into inflation protected vs nominal bond funds, greater flows in short dated vs long dated bond funds and greater flows into cyclical sectors and equity funds in general as the best equity and cyclical sector returns are typically seen at the end of the cycle.
On the credit flow side, there should be less distinction as credit should respond to higher uncertainty and volatility and underperform under both Fed policy mistake and end of cycle dynamics. “So the weakness seen in credit flows this year, especially in HY bond funds, is in our opinion less useful in helping to distinguish between the two hypotheses.”
With that in mind, JPM then goalseeks recent fund flows to determine which pattern fits the proposed flows. It does so by observing five flow metrics:
- 1) The trajectory of equity fund flows in generally. After a record monthly inflows into equity ETFs and MFs in January this year of nearly $130bn, flows turned largely neutral overall since then with modest outflows thus far in April (as seen in this chart).
- 2) Flows into cyclical vs defensive equity sectors. Figure 6 shows that since the equity market peak in end-January, inflows into US sector ETFs have tended to favor more cyclical sectors such as materials and financials, while outflows have focused on somewhat more defensive sectors such as utilities and healthcare.
- 3) Relative flows in inflation protected vs nominal bond funds. Figure 7 splits overall US government bond ETF flows into nominal and inflation-linked bonds. Nominal bonds have steady inflows since the start of the year, while flows into inflation-linked government bond ETFs have turned more neutral since early February.
- 4) Relative flows in short dated vs long dated bond funds. Figure 8 shows that the duration impulse of flows into US bond ETFs has decreased this year, with inflows going mostly into shorter-term and floating rate rather than longer-term bond ETFs.
- 5) Flows into interest sensitive sectors such as REITS. REITS have seen outflows YTD, with relatively larger outflows from US REITS.
Putting the above together, JPM summarizes that flow metrics 1, 3 and 5 look more consistent with the Fed policy mistake hypothesis, while flow metrics 2 and 4 look more consistent with the end of cycle hypothesis.
JPM’s conclusion: “while we recognize it is difficult to distinguish between the two hypotheses, there appears to be currently more flow support for the Fed policy mistake hypothesis.“
In other words, between Trump’s recent warning to expect “pain” in the market as he launches trade war, and the market suddenly pricing in either a policy mistake as the Fed hikes into a recession, or the end of the hiking cycle (in a subsequent post we will show why Citi agrees with this), it would explain the recent market selloff and spike in volatility, as forward-looking investors and traders simply look to cash in their chips as suddenly the market is signalling that the trading environment observed just before the tech and credit bubbles burst, is once again imminent.