The US Treasury curve inverted sometime in 2nd half of last year.
A curve inversion happens when the long end of the curve (i.e. long-dated Treasuries) yields less than the front end of the curve.
This is an economic indicator worth paying attention to because the Treasury curve inverted prior to every recession since the 1970s (recessions shown in this following chart as gray bars, which consistently follow periods where the blue line dips below zero, indicating an inversion):
Source: St. Louis Fed / FRED
Every time the blue line goes below zero, a recession tends to follow.
The inversion of 10 year Treasury and 3 month T-bills hit in mid-November of last year:
Source: St. Louis Fed / FRED
However, the 10 year Treasury and the 2 year Treasury had already inverted even earlier around July:
Source: St. Louis Fed / FRED
This likely signals a pending recession somewhere on the horizon.
We are not breaking new ground with this observation, though, since this is a well known relationship and likely something you have read about recently. Like here.
What I do think is additive is discussing why this relationship might exist, which would give us a better idea of what we should do.
Capital Flywheels believes it has a lot to do with how curve inversion affects credit creation.
Rather than taking the shape of the curve as Magic, we can reason through first principles a direct relationship between how the curve is shaped and how economic activity will evolve.
In normal times, the curve is shaped upwards because time value of money is positive. Investors should be positively compensated for committing their money for longer durations of time, not least to account for risk and uncertainty related to the passage of time. The yield an investor gets for lending money to the US government (i.e. buying a Treasury) should therefore increase as the duration increases.
Not only is this true for Treasuries, it is generally true for all assets.
However, what is most important to recognize is that credit and lending are central to modern economies.
The largest conduit of credit and lending is through the financial system such as banks.
There is simply no modern economy if there is no financial system.
How do these two things connect together?
Banks and financial institutions, generally, operate by borrowing short and lending a little longer.
This means perhaps taking deposits (which you can theoretically withdraw at any time) and then redeploying it as a business, auto, or mortgage loan (longer duration commitments that can’t be unwound quickly).
Since the yield curve is generally shaped upwards, borrowing short and lending long ALSO means borrowing low and lending high. As long as the yield curve is shaped upwards, you have a money-printing machine.
If you put 2 and 2 together, you can probably infer what happens if the curve inverts.
Instead of borrowing low and lending high, you end up with borrowing high and lending low. Instead of a money-printing machine, you now have a money incinerator.
However, the result won’t actually be banks lending low if the banks are smart…the result will be that banks will stop lending altogether.
And if the banks are not smart, they end up in bankruptcy sort of like what we saw with SVB and others.
Since modern economies run on credit, the moment credit creation ends, the result should invariably be a recession.
With the curve so deeply inverted, normal economic processes suggest that a recession is almost unavoidable because credit creation is quickly screeching to a halt.
You do not need to see widespread bank bankruptcies for this to happen. Normal functioning banks will also choose to slow credit creation. It’s simply not easy to make money with a deeply inverted curve without taking some even greater risks.
So what does this mean?
While many investors are already somewhat fearful of a pending recession, Capital Flywheels thinks a soft landing is possible.
Definitions are important here…and to see why there is a narrow path to a reasonable outcome will depend on defining precisely what it means to have a recession.
A recession is approximately defined as negative real GDP growth. The key operative word here is real.
Normally, recessions are bad for stocks because negative GDP growth tends to lead to lower earnings.
But we are not living in normal times.
Stocks perform based on how financial metrics (e.g. revenue, earnings, cash flows) evolve relative to expectations.
While these metrics are correlated with real GDP growth, they are actually more directly correlated with nominal GDP growth.
We are not living in normal times because inflation is running higher than normal!
Even if real GDP growth turns negative, there is a good chance that nominal GDP growth can remain positive. And companies with pricing power may continue to surprise on growth (or at least deliver “less bad” results than expected).
For example, 2008/2009 was a deep recession…even in such a deep recession, real GDP growth “only” declined 2.6%:
Source: FRED
Given that inflation was pretty low back then, the nominal GDP growth was not that different (and still negative):
Source: FRED
While everyone is reasonably concerned about another deep recession like the last one, I do wonder if that is misplaced…
Inflation is much higher this time around. Even if real GDP turns negative, you only have to look at the nominal GDP chart to see why revenue, earnings, and cash flows may still continue to come in better than expected.
Inflation should be declining from here, but we’re very far away from 2% inflation. Getting to 4% would already be a cause for celebration.
And if real GDP taps zero or turns slightly negative (perhaps -0.5%), Capital Flywheels is willing to bet that some companies will continue to surprise.
Not all…but some.
There will be moments where everything gets tossed out the window because “RECESSION”!
But these moments may prove to be good times to sift through and find the few companies that do have pricing power and are masters of their own destinies.
Recessions are usually good times to look for bargains. I suspect this will be even more true this time around.