Inversion Analytics Suggest Bottom In Long-Term Treasuries, Points To Fed Cuts In 6 Months

US Treasury Yield Curve

It is a relatively rare and powerful phenomena which occurred again in 2022: the U.S. Treasury yield curve has inverted. To decode and analyze it further, let's start with a longer-term overview about the U.S. government bond yields and federal funds rate. Yields have been in a structural decline since the 1980s, as the U.S. won the decade-long battle against inflation. From 1955 to 1981 (26 years) the U.S. was in a structurally rising rate environment. The Fed had to raise rates to 19% in 1980 to break the decade-long great inflation. From 1981, a structural decline in the federal funds rate and bond yields had started.

The important question is, what is driving rates and yields at different maturity. As the market perceives the Fed and the U.S. Government as risk-free borrowers, there is no credit component to consider in U.S. Treasury yields or federal funds rate. One can observe that long term both the 10-year bond yield and the federal fund rate follows the changes in consumer prices. The Fed adjusts its policy rate to reduce or support inflation by raising or lowering the cost of credit in the economy. The Fed determines the interest paid on bank reserves to set the policy rate.

Short-term Treasury bill yields are primary pricing the current and perceived Fed policy rate curve for the maturity period. History suggests that the Fed policy rate has a cycle of 4-6 years from first raising and last cutting. Therefore, the long-term yields are pricing long-term inflation and growth expectations, as a 10-year bond will potentially experience multiple Fed rate cycle through its lifecycle.

Obviously, the current rate cycle greatly effects longer-term yields as well, however, there could be large differences between shorter and longer-term yields. One such large difference is when the yield curve inverts, whereas the longer-term yields are below the shorter-term yields. We can observe that the yield curve is typically upward sloping, which means longer-term rates are above shorter-term yields. Structurally, all rates and yields are heading in the same direction, which is determined by inflation, however, short-term yields and rates fluctuate more.

From 1983, the yields and rates have been in a structural decline due to structurally declining or stabilizing inflation. The policy rate still experienced shorter 4-7 years cycles, however each low and top was below the previous cycle. This 40-year sequence broke in 2022, as the current Fed rate and yields are at or above 2007 levels, representing a 16-year high.

It is important to note that the U.S. Treasury bonds are regulatory requirement for banks, insurance companies, and pension funds. Other than them, mutual funds, hedge funds and money market funds are actively engaged in this market. Foreign central banks holds their dollar reserves in U.S. Treasuries, as well as its the global financial system's primary source of collateral for dollar borrowing. Arguably, it is the most liquid market in the world. More than that, it represents the risk-free rate for a certain maturity, therefore, provides the base for all type of lending and borrowing activity, such as mortgage rates, credit card rates etc.

The available treasury yields and real yields are greatly effecting the exchange value of the dollar, therefore, the global financial system and economy. The discount rate of future cash flows in the asset valuation is usually the 10-year treasury yield, therefore, it is a crucial component of equity and real estate valuation. For all of these reasons, it is highly important to decode the treasury curves and understand what it signals us. Assessing longer-term inflation driven trends will be a subject of a separate article in the near future, however, shorter-term current cycle dynamics will be in focus, mainly the yield curve inversion phenomena.

Inversion

This is a relatively rare and an abnormal condition, as longer-term yields should compensate you for locking in your capital in the form of term premia, over rolling your capital over in shorter-term bills for the same period. When the yield curve inverts, the term premia gets negative. The explanation for this lies in the expectations of future policy rates will be lower than currently, such as the case now as well.

The 2024 & 2025 December contracts have been pricing lower collateralized 3-month lending rate than the 2023 December rate, since 2022 February. (SOFR = SECURED OVERNIGHT FINANCING RATE). Currently, the market is pricing in 85 bps (0.85%) lower secured rate in 2024, and 136 bps (1.36 %) lower rate in 2025 December. These numbers can fluctuate greatly over time, as the yields represent the weighted average probability of the market consensus. Therefore, as the marketplace has been expecting lower rates in 2024 and 2025 than in the current year since the Fed began tightening, long-term treasury yields are priced accordingly, and if enough rate cuts are priced in than the treasury yield curve inverts.

Since 1955, the 10-year US Treasury note and the 3-month Treasury bill inverted 8 times, plus the 9th is the current inversion cycle since 2022 November. The yield curve inversion is a very powerful phenomena, which signalled all of the past financial and economic downturns with very few or none fake signals, depends on which part of the curve inverts. When the marketplace expects the Fed rate to go down in the future, it is typically associated with worsening economic and financial system outlook. When the marketplace expects that growth and inflation and, therefore, policy rate will be lower in the future, longer-term yields are more attractive and, therefore, they decline due to more demand, while the shorter-term yields are pricing higher current policy rates. As the treasury market consists of the largest and most influential agents of the global financial system and economy, their consensus has great predicting power, if it is being interpreted correctly.

Different parts of the curve inverts at different times, as the 10-year 2-year inverted in 2022 March than 2022 July and onwards, meanwhile the 10-year 3-month yield inverted in 2022 October.

Now, to dig deeper into who is buying, an important player, the U.S. commercial banking system's treasury holdings have been declining as the market price of existing ones declined, but they have been net buyers of treasury and agency securities since 2023 April since the banking crisis. The commercial agents in the U.S. Treasury market (banks, dealers, etc.) are the 3rd most bullish on the 30-year Treasury bond future in the past 20 years, based on the (COT) report. The primary dealer network, the global systematically important banking group is $229 billion net long U.S. Treasuries in their secured financing and securities lending activities, which is the second most bullish in the past decade.

Obviously, there are many more agents in the treasury market, such as the FED who stopped its treasury purchase as it is reducing its balance sheet (QT) since 2022. However, the world largest banks, the primary dealers, the commercial agents in the treasury market and since April the broader commercial banking system are net buyers of the U.S. Treasury market. This is where part of the demand comes which inverted the treasury curve. A very important factor in the treasury market is the demand due to risk aversion of the global financial system, which is what arguably we are witnessing now. Note that these treasury securities are subject to securities lending and repo activities, whereas the actual obligations to deliver the bonds are much larger than the underlying treasury securities, and can work as a short squeeze in the financial system during excess risk aversion.

One possible indication of the risk aversion is the gross outstanding repo, RRP, securities lending exposure of primary dealers. The 3-month average of gross outstanding financing collapsed by a $trillion since 2023 May, but rebounded since. The collapse in financing activity in 2022 was more severe as it reduced by $2 trillion. Note that in an expanding risk seeking financial system, the wholesale financing activity should continuously and structurally rise, which hasn't been the case at all since the Great Financial Crisis. This raises important questions about a structural risk aversion in the global primary dealer network.

Inversion Analytics

Arguably, the 10-year 3-month yield curve inversion has the best track record in predicting downturns. Therefore, analysing on average how critically important assets such as long-term treasuries, SP500, dollar as well as fed fund rate and growth changes prior and after the curve inverts can let one have great insights into the underlying dynamics. When comparing the current cycle with the historical average, the direction and trends are more important than actual levels.

Growth & Budget Deficit

Growth of the cyclical, the most real-time part of the economic data, is the average of employment, industrial production, personal income and personal spending. Currently, the U.S. cyclical economy is 0.41% higher in real terms compared to the inversion point, whereas on average 10 months into the inversion, the growth rate is -1.5 % lower. It seems like more resilient growth first, however, when assessing the unusually large and sharp rise in the federal budget deficit, it paints a less rosy picture. When adjusting for the budget deficit, the private sector growth rate is weaker than it is on average 10 months after the curve inverts.

Usually, the government expands its budget deficit as cyclical growth weakens, however, this time the federal government tries to front-run the economy and keeps it in the positive growth territory by ballooning deficit. Perhaps, it is in relation with the 2024 elections. This revelation points to worryingly weak private sector where the sustainability of this level of federal spending is questionable. Should the government support fade, the economy may weaken asymmetrically.

When we compare nominal growth with the inflation rate, we can observe that on average nominal growth decelerates more than the inflation rate 9-month prior to the inversion, and gets below the inflation rate (contraction) from the 17th to the 31st month after inversion. That would put us in an economic contraction period from May 2024 to 2026 March. One can observe that the real Y/Y real growth rate of the economy was dropping heavily and much more sharply than usually, however, has stabilized and slightly rebounded since, perhaps due to the ballooning budget deficit. The cyclical U.S. real economy was growing by 1.59% in October compared to the average 2.58% in the 10th month after inversion. Note that after the Great Financial Crisis, the U.S. economic growth rate materially slowed, therefore, it is somewhat normal for experiencing slower growth rate than at average inversion cycles.

Inflation

The changes in consumer prices have been running at a slower pace than the historical average since the 6th month of the inversion cycle, however, it grew at a faster pace from 8-month-prior to 5-month-after period. On average, inflation peaks 17th month after inversion, which would put us to 2024 May.

Fed Funds Rate

On average, the Fed starts heavily cutting rates between 14 and 17-month after the 10-year 3-month curve inverts. Interpreting that puts us between 2024 January - March as the period where the Fed starts to cut. It is important to note that the Fed cuts might be delayed due to fears of inflation reaccelerating, and the government ballooning deficits are hiding private sector weakness. To conclude, we are in the part of the inversion cycle where heavy Fed cuts may around the corner in the coming quarters. Note that the average data contains periods from the great inflation as well, therefore, it is inflation neutral.

10-Year Yields

On average, the 10-year yield (NASDAQ:IEF) rises sharply from the 8th to the 11th month after the curve inverts. We had that in this cycle as well from 2023 July-2023 September. On average, the 10-year bond yields peaks in the 11 months after inversion, and starts heavily declining in the 16th month. That points to yields peaking in 2023 October, and starts falling in 2024 March. Note that both the fed funds rate and 10-year yields track very closely the average trend after inversion, just with much higher volatility. The 10-year is effected by the Federal funds rate, so delays in Fed cuts can cause the 10-year yield decline to delay as well. Either way, this signals the bottom can be in anytime now in longer-term treasuries, (IEF) (NASDAQ:TLT), at this part of the cycle.

SP500

The SP500 (SP500) (NYSEARCA:SPY) decoupled from the average yield curve inversion trends. The market started falling 10 months before the yield curve inverted, and rebounded sharply when the inversion happened. This indicates, the market is currently pricing longer-term inflation and rate projections rather than economic outlook. This may change if major economic or financial weakness emerges further, and the market starts falling to price in the deteriorated growth outlook. Note that currently the SP500 is pricing a double digit YoY earnings growth for 2024, which is inconsistent with the growth outlook of the coming period of the inversion cycle.

US Dollar

The US Dollar (DXY) completely decoupled from the historical average, as after the Great Financial Crisis, the conditions have changed in the dollar market. There appears to be a structural dollar shortage and relative weakness compared to the U.S., therefore, the dollar appears to be in a structural uptrend for the past 15 years.

Conclusion

The 10-year 3-month curve inversion analytics suggests that the 10-year treasury yield and Fed funds rate are closely tracking the trends in the average inversion cycles, just with higher volatility. If that relationship holds, it would point to heavy Fed rate cuts and a collapse in the 10-year note yield starting from 2024 Q1. This suggests the bottom should be in or around the corner anytime in the 10-year T-note price (IEF) and probably in the long term bond as well (TLT), which is supported by banks and dealers positioning.

In this inversion cycle, we experienced a faster than average initial slowdown in real growth, which has stabilized since around 1-1.5 % YoY. However, the stabilization and the slight rebound can be associated with unusually sharp rise in government deficits. Without the effects of the budget deficit, the private sector economy hasn't stabilized but have continued to slow further tracking closely the average trend. The analytics revealed that the economic contraction supposed to start somewhere in 2024 May and last until 2026 March. Should the government not be able to sustain the level of spending and deficit, the economic contraction can be asymmetric. Inflation has started to deaccelerate earlier than average in this cycle, as the average would put the start of the deceleration for 2024 May.

The SP500 (SPY) decoupled from the historical average trend as the markets have been currently pricing inflation and long-term rate prospects. There is a significant probability that markets will start falling on lower growth prospects once we are getting closer to that potential contraction period starting in 2024 Q2 and on a negative surprise in earnings outlook.

In conclusion, it is way premature to conclude any soft-landing before the end of 2024. The highest probability is an economic contraction starting in 2024Q2 and lasting for 19 months. Should the excess government spending normalize, it could potentially lead to a more severe contraction which is probably not fully priced neither in equity or bond markets. This suggests a significant upside in longer-term bonds IEF, TLT and an increased downside risk in equity markets SPY, QQQM due to overly optimistic growth outlook priced in for 2024.