Yield Curve Dynamics and Economic Warnings

In the past week, the global bond market has witnessed a surge in bond yields, especially medium- and long-term bonds. There have been quite a few discussions about the US bond 10Y-2Y yield curve being inverted for nearly 1 year, suddenly turning back up. The question is whether the bond yield curve is “normalizing” or signaling an impending recession cycle like in 1992, 2000, 2008, and 2020?

This weekend's macroeconomics column from Viet Hustler will answer readers' questions from the past week about a series of information related to bond yields, on financial newspaper headlines and on Viet Hustler's news page. Among them, the main questions include:

• What is happening to the trajectory of the yield curve?

• The relationship between the bond market and stock market performance in similar past economic situations.

• Is the yield curve that was inverting but rising again a sign of an economic recession?

All will be discussed in the article below. 

Disclaimer: some opinions below are based on observations and assessments of Viet Hustler, for reference only, and are not investment advice at all!

What is happening in the bond market and the US T-bond 10Y-2Y yield curve?

• T-bond 10Y yield surges, especially after the US jobs report last Friday (below).

  

  • The jobs report shows an addition of +336,000 payrolls in September 2023 - double the forecast (+187,000).

    • It can be seen that the bond market reacted quite sharply to the surging NFP payroll number, almost ignoring other positive information such as wage growth lower than expected and unemployment rate higher than expected. 

    

• But not only in the US, the world's largest bond markets are being hit by heavy sell-offs…

  (due to concerns about government debt repayment ability accompanied by recession risk). 

  • Global bond yields are rising rapidly, now much higher than the average over the past 10 years:

    

  • Global bond values have lost an additional -USD 1,040 billion in just the past month, bringing the total bond losses to -USD 3,900 billion since mid-July 2023.

    

• Notably, unlike the previous period when short-term bond yields rose rapidly, in the past 3 months, the rate of increase in medium- and long-term bond yields (10Y-30Y) has accelerated faster.

• Because the 10Y bond yield has risen faster than before, the US 10Y-2Y yield curve, which was previously inverted (inverted yield curve) for 225 consecutive days, has now turned back up (“uninverting”). 

  

• This can be explained by a term that Viet Hustler mentioned in the macroeconomics article discussing public debt from last week: bear-steepening.

  • The trend “bear steepening” occurs when interest rates across all bonds rise, but long-term bonds (or those with longer maturities) have a higher rate of interest rate increase (higher delta) - green bar chart below.

  • => thus shifting the entire expected Fed funds rate curve (implied rate curve) higher in the long term - orange line chart above (Market-implied Fed Funds).

  

Causes of bear steepening?

• Bear steepening at the present time may be driven by the influence of the looming public debt crisis:

  • … as investors are concerned about the government's debt repayment ability, especially in the long term.

  • Therefore, they sell off long-term government bonds and demand higher yields for long-term government loans. 

• And high yields making the US government's borrowing costs higher will exacerbate the fiscal deficit and escalating public debt in a vicious cycle (debt trap?).

  • Goldman Sachs estimates that US interest payment costs alone (as %GDP) will continue to rise due to higher borrowing rates: 

    rising from 2% GDP in 2022 => 3% in 2024 => 4% GDP in 2030.

    

It's also not wrong to say that the yield curve, which was inverted, turning back to steepen due to “bear-steepening” is a sign of recession, but only under the condition of a high interest rate environment (which is the current situation). 

The reason is:

1. When bear-steepening occurs in a low interest rate environment: it encourages people to deposit long-term savings.

   Businesses and the government are also willing to borrow medium-to-long-term loans to invest in large projects.

2. When bear-steepening occurs in a high interest rate environment, that is, interest rates for medium-to-long-term loans (>10Y) for both businesses and the government will be “extremely high”:

• This will limit businesses and the government from borrowing long-term capital, while most investments in infrastructure and large projects occur in the long term. 

  • => Businesses and the government limit or have no new projects invested ~ economic growth stalls.

  • After bouts of “bear-steepening”, stock investment performance has been negative for a long time (several years),

    … simply because of poor liquidity, as capital is locked into long-term bond debt, causing businesses to operate poorly (due to inability or unwillingness to borrow long-term capital). 

    

• Bear-steepening + high interest rate environment will further prolong the credit crunch period:

  • because capital from individuals and credit institutions will flow into medium-to-long-term bonds (this hasn't happened yet, but may occur in the near future).

  • => Market liquidity will deteriorate as capital is (wanted to be) locked into medium-to-long-term debt.

• Alternative impact on consumption-saving: People also limit spending and save long-term (due to higher long-term deposit rates). 

  => Spending, consumption decline => economic recession.

From declining consumption, stalled growth (due to few long-term projects being invested in), poor liquidity in the financial market, the economy will lack development momentum and slide into prolonged recession. 

Back to the soft-landing and recession story…

• The phrase “soft-landing” is being mentioned more than ever, more than before the Great Recession in 2008 and the dotcom crisis in the 2000s.

  

• However, when everyone hopes for a soft-landing, they will spend more actively, businesses continue to burn through cash reserves believing that the Fed will pivot in time when they need to refinance.

  • => Economy still grows, inflation still above target.

  • => Fed will still keep rates high.

• And when businesses realize that the Fed (or central banks) will not cut rates as soon as they previously expected, they will have to refinance at high interest rates. 

  • => Businesses cut production, lay off workers, and reduce wages. 

  • => Unemployment rises, income falls, people tighten their belts.

At that point, recession will truly occur and become even more severe!

Signs indicating the above phenomena have begun to appear:

Central banks are increasingly tightening monetary policy because there is no clear fracture in the economy yet:

• The latest data on the balance sheets of G7 central banks (CBs) continued to decline in September, reaching the lowest level since June 2020.

High interest rate policy is gradually spreading to the financial market and the economy:

• In the financial market:

  • US banks are suffering enormous unrealized losses (one of the causes of the small bank crises from March 2023)

    

  • Banks are also unwilling to finance M&A deals due to high interest rates and high default risk of businesses: 

    • The value of global M&A deals has fallen -45% this year to ~384 billion USD, the second consecutive year of double-digit decline.

      

  • Life insurance companies are also institutions holding large amounts of bonds; they use bonds as collateral for their debts.

    • Insurance companies' stock prices fell immediately after the SVB collapse, and are now falling again due to a sell-off wave pushing bond yields higher:

      

  • Small companies are facing difficulties in borrowing: small company bond yields are rising higher compared to Treasury bond yields (junk bond spread widening).

    

• Consumer demand is declining and economic activity is stagnating

  • Citibank reports a decline in credit card spending data:

    

  • Non-revolving consumer credit loans in the US have also unexpectedly declined:

    

  • US gasoline and oil demand has fallen to the lowest seasonal level in the past 25 years.

    

  • Contracted road freight volume has dropped -1421.85 points in the first week of October.

    (possibly also due to the impact from the UAW auto workers union strike)

    

  • The composite index of home purchase applications has fallen -5.7% (to 136.6) - the lowest since 1995. 

    

CONCLUSION

In the past week, there have been quite a few discussions about the US 10Y-2Y bond yield curve, which was inverted, suddenly steepening again. The reason may be due to bear-steepening as medium-to-long-term bonds are seeing faster yield increases than short-term bonds. This bear-steepening may be driven by rising US government debt with surging interest payment costs (due to high interest rate policy from the Fed). 

Bear-steepening, if in a normal economy with low interest rates, is considered a positive market move in adjusting the risk-return balance (risk-return correction) of bonds with different maturities. 

But in a high interest rate environment, and an economy gradually slowing down, the bear-steepening of the yield curve could amplify the impact of a severe and prolonged credit crunch: 

• Capital will want to flow into long-term bonds (locked in for a long time). 

• Meanwhile, businesses have no incentive to borrow long-term due to high interest rates. 

The result is, consumption decreases (due to the substitution effect between consumption and saving by households), businesses cut back on long-term investments and lay off employees, unemployment rises, income falls, further reducing consumption. A recession will truly occur. And in reality, there are quite a few signs of credit crunch and slowing consumer demand emerging, as mentioned above.

In the context of a chaotic market, central banks (CBs) remain very firm in their rate-hiking process. That is because the purpose of their tight monetary policy is to slow the economy through reducing demand, thereby reducing inflation. And as Viet Hustler has emphasized many times, despite facing recession risks, CBs are doing their duty: price stability! (Price Stability!)