IGSB - Don't Confuse Nominal Yields (Inflation) With Yield Curve (Economy)

Summary

• Some think we're witnessing the largest disconnection in history between bond yields and the economic cycle.
• They expect yields to tank in tandem with the slowing economic growth. Had this been true, yields should have already been significantly lower.
• We, on the other hand, believe that investors must differentiate between nominal yields and the yield curve. They belong to the same family, but they are not similarly related to the economy.
• Yield curve is a better indicator (than nominal yields) for the state of the economy. UST10Y is a better indicator for the course of inflation.

A week ago, I bumped into a tweet by Raoul Pal (Founder/CEO of Global Macro Investor and Real Vision), where he posted the below chart together with the following claim: "Bonds have the largest disconnection vs business cycle in history...also vs. inflation and the dollar."

One week later, the US Treasury 10 year yield ("UST10Y") is higher by another 10bps, but it's closing fast on the multi-year high it reached a few months back (only 13bps away).

Don't get us wrong: We're not suggesting that bond yields should be higher or lower for that matter. What we're claiming is that instead of using the economy to project where yields "supposed" to be, we should feel the economic pulse through yields.

Putting it differently, in the endless "chicken-and-egg" debate, we believe that yields (and the yield curve) are telling us where the economy (and inflation) are heading more than the economy is telling us where yields "should" be.

If economic growth would have been a leading indicator for yields, UST10Y would already be trading way lower than where it is. After all, the US economy has been weakening for over a year now, and yet yields have only gone up (a lot) during that time.

We already know that yield-curve inversion is the most reliable barometer for an upcoming recession.

Although the 10-2 Year US Treasury Yield Spread ("10Y-2Y") is the most popular spread, the 10 Year-3 Month US Treasury Yield Spread ("10Y-3M") is considered to be even more reliable.

The 10Y-2Y is already inverted for about two months, but the 10Y-3M has so far "refused" to join, and it keeps hovering only slightly above the flatline.

If the Fed keeps with its hawkish stance, and Fed Funds are going to rise closer to 4% (as current market expectations are pricing), one of two will need to happen: Either the 10Y-3M inverts too (implying with a near-certainty that a recession in the US is coming) or the UST10Y will need to limb higher than the 3M yield, suggesting that the 10-year yield might be ~4%, perhaps even higher than that.

If so, the first chart in this article would see a much greater divergence between the ISM and the Y/Y change in the UST10Y. Putting it differently, while the economy will be in a lower/worse position, yields will trade even higher than current levels.

The "largest disconnection" between bonds to the business cycle in history will become even more disconnected than it is already.

What's causing and feeding this disconnection? Inflation on one hand, and very weak credit markets on the other hand.

As for the latter: Not only is the Fed (and other major central banks) starting the long process of unwinding their enormous balance sheets, but the soaring rates/yields are making it very hard for corporations to refinance.

There is no better place to see this other than the high yield bond market, which is suffering the worst year (from new issuance perspective) since 2008.

As for the former: Inflation is going to move down; there's no doubt about that. When you raise rates so much and so fast - you're killing demand, and sooner or later the effect will be felt.

Thing is, inflation expectations have fallen so much, so fast, that the market is now pricing a "back to normal" (inflation of ~2%) in no more than a year time.

From the current Y/Y pace of +8.5%, investors believe that a year from now we will be back to around the Fed's long-term target of 2%. If and when, that would be a huge drop, and the question is, aren't investors too optimistic about the inflation genie moving back into the bottle so quickly?

Bond yields tell us that the road towards normal inflation levels might be more bumpy than many (currently) assume.

I mean, what inflation expectations are mostly based on? A serious economic slowdown, let alone recession. If so, why don't bond yields already reflect that outcome? The only explanations for (long-term) bond yields remaining that high are:

1. Inflation won't move down as quickly as current expectations suggest.
2. The US economy will fare better than expected and won't enter a recession.

Of course, both explanations are valid and can be used together, but if we force you to choose only one out of the two, which explanation would it be?

We believe that the first explanation, i.e. inflation might prove to be more sticky than many expect, has more substance.

In just a couple of hours the US CPI figures for August will be out, and we expect a trading day with extreme volatility that will affect all asset-classes: stocks, bonds, commodities, currencies, cryptos, etc.

Interestingly, stocks and bonds are sending very different signals about inflation. While stocks say inflation is dropping fast (say <=8% Y/Y pace), bonds are expecting a smaller drop (a figure closer to 8.5% than to 8%).

We strongly suggest investors trust bonds (credit markets) more than they rely on stocks (equity markets). The latter are making more noise, but the former are paving the way.

Don't ask where yields "should be" based on the economy rather where the economy is (likely) heading based on yields, or even better: Yield-curve.

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