By Sage Advisory

Crossing the Rubicon – Yield Curve Inversion

In 49 BCE a provincial governor named Julius Caesar and a single legion of troops crossed a small stream in northern Italy – the Rubicon River – sparking a civil war that led to Caesar’s reign and changed the course of history for Rome. Today, the phrase “Crossing the Rubicon” serves as a metaphor for taking irrevocable steps toward an outcome. In the financial markets, no indicator of an economic recession is as synonymous with the Rubicon as the slope of the yield curve crossing into negative territory.

The first week of trading in December saw the much-awaited inversion of the yield curve, with the 5-year Treasury yield trading below the 2-year yield for the first time since June 2007. Another commonly cited yield curve measure, the spread between the 10-year and 2-year, has not yet moved into negative territory, but typically follows the 5-year and 2-year spread into inversion territory.

Yield Curve vs Recession

Source: Sage, Bloomberg as of 12/6/2018

Historically, the yield curve has proved to be an accurate indicator of economic recessions. In the 1980s, early 1990s, early 2000s, and at the dawn of the Global Financial Crisis in 2006, the yield curve inverted in advance of a recession. What does the inversion signify and how does it contribute to the market outlook going into 2019?

An inverted yield curve is a symptom of tightening monetary conditions from the Federal Reserve, which serves to slow credit, asset price, and economic growth – and typically results in a recession. The degree of the slowdown depends on the fragility of the underlying economic picture. The Fed has the difficult task of keeping conditions such that the economy grows at a sustainable rate, but not so fast as to produce asset bubbles. The additional factor of the unwind of Quantitative Easing, for the first time since the 1930s, adds to the degree of difficulty of this task.

The markets are preparing for the end game of the current economic expansion. We expect a further period of higher volatility and low liquidity, absent additional public support through fiscal stimulus or markedly more accommodative policy from the Federal Reserve.

Yield Curve Inversion is a Symptom of Tight Money Policy, not a Trigger of a Potential Slowdown

Fed tightening typically involves raising short-term interest rates to the point where financial conditions become sufficiently tight to create economic headwinds and cast doubt on future growth. That doubt on future growth could manifest into a flatter yield curve and demand for longer-duration assets versus shorter-duration assets. During the most recent Fed Cycle, the flattening of the yield curve has coincided with continued Fed hikes.

2y-10yr-yield-curve-vs-fed-hikes

Source: Sage, Bloomberg as of 12/6/2018

In fact, Fed hiking cycles typically result in flatter curves. Looking back to Fed hiking cycles starting 1976, the chart below shows that Fed hiking cycles coincide with a decreased slope of the yield curve.

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