Armando Alizo’s Post

Mastering the yield curve is a crucial skill for macro investors. Let's learn a few tricks together. We have all heard that yield curve inversions tend to precede recessions. Yet this analysis doesn't help unless you include the following context: - The sequencing and the macro lags; - The last shoe to fall: the late-cycle steepening! This is the mechanism by which a yield curve inversion ultimately leads to recessionary conditions. 1. The Central Bank raises rates aggressively 2. Markets signal conditions are too tight: the yield curve inverts 3. The curve stays inverted for 12-24 months (!) Ok, let me stop here for a second. The point number 3 is crucial: the macro lags matter! Only when the yield curve has been inverted and financial conditions have remained tight for a long time conditions can become recessionary. The passage of time is a boring but key variable: the longer conditions are tight, the bigger the share of private sector agents that are negatively hit. In other words: if conditions remain tight for long enough, more households and corporates will actually need to refinance their debt at tight conditions! Ok, back to the sequencing now. 4. The economy slows 5. A late-cycle yield curve steepening (!) happens This is often the last shoe to fall before a recession kicks in: let's see why. As the charts below show, you can get the steepening in two ways: bear steepening (left) or bull steepening (right). Bear steepening means yields are going higher and particularly at the long-end of the curve: such a move late in the cycle increases the chances of something breaking in markets. When long-end rates move up fast even if growth conditions don't justify that, leveraged business models (housing, pension, banks, credit markets etc) can easily crack under pressure. Late-cycle bull steepeners happen when nominal growth is slowing rapidly and the Fed is seen to be forced to cut rates: the front-end rallies aggressively and the accommodation is seen as holding the sky from falling hence the curve steepens. A late-cycle bull steepener tends to signal the Fed has done enough damage and it will be forced to cut as the recession approaches. 6. Finally, a recession occurs. Recap: 1. The Central Bank raises rates aggressively 2. Markets signal conditions are too tight: the yield curve inverts 3. The curve stays inverted for 12-24 months (!) 4. The economy slows 5. A late-cycle yield curve steepening (!) happens 6. Finally, a recession occurs Where are we today? You are now at month number 16 post inversion, the economy has slowed, a late-cycle steepening has partially happened. If history is any guide, the next 6-9 months might be tricky. P.S. Two-weeks free access to my research? Contact me (Alfonso Peccatiello) via BBG chat!