Thursday, 29 August 2019

How worried should we really be about an inverting yield curve?

In an interview a few years ago, Elon Musk responded to a question on what had enabled him to innovate so effectively by saying: "I think it's important to reason from first principles rather than by analogy. The normal way we conduct our lives is we reason by analogy. [With analogy] we are doing this because it's like something else that was done, or it is like what other people are doing. [With first principles] you boil things down to the most fundamental truths... and then reason up from there". (He might also have added that, unlike many others, he has not been constrained by the need to generate a positive return on capital, but I digress).

Musk's comment resonated with me immediately, because reasoning by analogy is something we see a lot in markets, and I have never found such arguments persuasive. They always felt dubious to me, even if I could not articulate exactly why. Musk's comment clarified perfectly for me what the fundamental problem with them was. They were not based on first principles.

A clear example of reasoning by analogy in markets is the frequent anxieties expressed about an inverting US yield curve. In cycles past, an inverting yield curve has often (though not always) preceded a recession, so investors view such inversions as particularly ominous. A widely subscribed belief in the inversion's predictive value can and has had market implications - an inverting yield curve contributed to the 15% market crash US markets experienced in December 2018, which proved to be a false alarm. By 2018 year-end, surveys revealed that a majority of investors expected the US to fall into recession in 2019. Instead, the US went on to print 3.3% GDP growth in 1Q19, and markets surged. More recently, the US yield curve has inverted again, which has contributed to another savage decline in US and global markets in August.

While you often hear concerns expressed about an inverting yield curve, it is much rarer to encounter a good first-principles explanation of why it has preceded past recessions and why we should be so concerned. Most investors reason purely by analogy, and are content to note that an inverting yield curve has been associated with past recessions. But as Keynes once said, if you do not know the underlying causal factors driving past experience, you are in no position to know whether present conditions are sufficiently similar to render past experience a useful guide.

One of the most common arguments made is that the bond market is more efficient than the stock market, and the bond vigilantes see recession coming before the equity guys. Baloney. Bond markets are buying 30yr government bonds at negative yields at present. Not very smart/efficient. Equities, being lower down in the capital structure, are also at the 'sharp end of the whip', so to speak, in terms of upside and downside exposure. If any market should sniff out trouble/risk first, it should be the equity market. There is no sound reason to believe the bond market is more efficient than the stock market, in my opinion.

The best first-principles explanation I have been able to uncover as to why a yield curve inversion has preceded many past recessions (and I would love investors to educate me in the comments if they have a more insightful explanation) is that in decades/cycles past, many banks/financial institutions borrowed short term wholesale money, and lent it long. In other words, there were many financial institutions running loan-to-deposit ratios (LDRs) meaningfully above 100%. So long as such institutions were able to borrow in the wholesale market and on-lend with healthy spreads (i.e. with a positively sloped yield curve), they did so, and grew their loan books (and profits) vigorously.

However, when short term rates rose sharply and began to exceed long term rates, the lending spreads of these institutions were sharply squeezed. Even if they had taken measures to protect themselves from interest rate risk on their back book (which sometimes they hadn't), the spreads on their new loan originations sharply deteriorated. This, predictably, resulted in a sharp slowdown in new credit origination, which in turn triggered an associated reduction in aggregate economic demand, and thus meaningfully slowed economic activity - particularly because virtually all recessions in the post-war period were preceded by years of double-digit system credit growth.

However, in the post-GFC period, a lot has changed. Interbank and other short term wholesale funding markets were severely disrupted following Lehman's collapse (whose own collapse was driven as much by a liquidity crisis - its short term funding lines dried up as counterparties lost confidence - as it was losses on the asset side of its balance sheet). The cascading effect on funding markets resulted in liquidity crunches and near-death experiences for many other financial (and non-financial) institutions dependent on short term wholesale money to fund their balance sheets/operations, and necessitated massive Fed intervention/bailouts to avoid large portions of the financial system collapsing.

The legacy of the crisis has been not only a voluntary change in bank behaviour (once bitten, twice shy), but also a significant tightening in banking regulation, including much stricter liquidity coverage requirements. Very few systemically important financial institutions are today running their businesses with any meaningful reliance on short term wholesale funding markets. Today, the vast majority of US financial institutions rely almost exclusively on deposits and (where necessary) longer term wholesale funding instruments, and the system LDR (loan to deposit ratio) in only about 70%. Indeed, the banks have (and have had for a while) excess deposits, and for the major banks at least, many of these deposits cost nothing or close to nothing (well below short term Fed rates).

It is true that QE has contributed meaningfully to this excess liquidity/deposits/reserves situation, and one might reasonably attempt to argue that banks will stop lending if they can make 2-2.25% on their excess reserves parked with the Fed if the yield curve inverts. But this ignores the fact that (1) most banks have been (and continue to) lend at rates significantly above the US 10yr (new mortgage rates are currently 3.9% in the US, for .e.g, vs. 1.5% for the 10yr), and unlike Japanese banks, US banks are managed for shareholders and RoE maximisation); and (2) US banks have been sitting on excess deposits/reserves for the entirety of the post-GFC period, and have been unable to find a useful place to lend them, even in a world with a meaningfully positive yield curve. That was almost never the case pre-GFC in periods of economic expansion. That's why LDRs remain so low; excess reserves so high; and credit growth so anaemic (see below). If credit growth is already slow and banks already aren't lending much, then an increased incentive to keep funds parked with the Fed will have limited effect, because that's already the status quo.

This brings me to another important point - the level of pre-existing credit growth. Over the past decade, private sector credit growth in the US (ex fiscal) has been very modest. This is extremely important, because it's hard to have a significant slowdown in credit growth triggered by an inverting yield curve, and the associated aggregate demand ramifications, if pre-existing credit growth has been modest.

It might surprise many people accustomed to reading bearish prognostications about the outlook for the US economy and the level of aggregate system debt, but US household debt to GDP has actually fallen over the past decade, from about 100% of GDP at the time of the GFC, to just 76% at present, and credit growth has continued to lag nominal GDP growth throughout the recovery, including the recent fiscally-induced acceleration (US household credit growth was just 2.3% in the year to 1Q19). The data is easily accessible for those who care to look. Both banks and households - chastened by the GFC - have borrowed/lent very prudently in the crisis' aftermath. This means there is less capacity for a sudden slowdown in credit growth due to tightening lending spreads, as loan growth is already modest. And US consumer spending - let it be remembered - drives about 70% of US GDP.

Corporate credit growth has been somewhat higher, and is therefore more of a risk, but credit growth has still been only a middling 7%, and at 52% of GDP, is not unreasonably high. After a dramatic decline during and post GFC, corporate debt-to-GDP has slowly risen back to its pre-GFC levels, but corporate debt was not the cause of the GFC, and interest rates (and hence debt servicing burdens on corporates) today are significantly lower.

Furthermore, the complaint we have heard most often over the past decade has been that US companies have been buying back too much stock and not investing enough, rather than investing too much, and with a few exceptions (e.g. shale activity), most of the over-investment that has occurred has been localised and equity-funded (VC funded tech). US corporates have been significantly under-investing over the past decade relative to the availability of credit (and their reinvestable profits), and so by extension, corporate investment is unlikely to sharply slow due to a reduced marginal appetite from banks to lend (shale being a probable exception here). Furthermore, even if financial institutions were to start rationing credit to businesses at the margin, falling sovereign yields have created a large class of financial institutions such as life insurers and pension funds that are desperate for yield, and so it will be relatively easy for creditworthy (and maybe also non-creditworthy) businesses to issue bonds at low cost. And this is before mentioning the many alternative 'credit' funds being set up at present to search high and low for any sort of yield. In such an environment, a generalised lack of access to credit to finance investment seems far fetched.

One of the key things that has changed in the developed world in the post GFC period, which many investors are still yet to have wrapped their heads around, is that we have moved from an environment of capital scarcity into a period of capital abundance. This has turned many of the prior economic relationships that existed in decades past (and which still prevail in emerging markets today) on their head. Richard Koo's excellent book The Holy Grail of Macroeconomics has a Yin/Yang model that discusses this in more detail, which I highly recommend (drawing on Japan's now three-decades of experience in having transitioned to an excess-capital position). Sure, when capital is scarce and needs to be rationed, a change in long rates that dramatically slows lending growth from vigorous levels can absolutely be expected to slow the economy. But that is not the world in which we are currently living (in the developed world).

All told, an inverting yield curve could prove to be far less predictive than it has in the past, and there is a decent chance that many of those 'reasoning by analogy' will be surprised by the resilience of the US economy, and its continued refusal to behave as it supposedly ought to. That does not mean there are not other important risks to the economic outlook (I have discussed the risk of a VC blow up in prior blog posts, for e.g., and the trade war also continues to impact corporate investment activity), but in isolation, betting on a recession merely because the yield curve has inverted appears to me to be a risky proposition.

I would love to hear from anyone who could critique this perspective. The anxieties (and algo bot reactions) to an inverting yield curve keep tanking markets from time to time, and if people are wrong about the predictive value of the indicator in the current environment, there is potentially significant money to be made on the long side buying into these sell-offs.



  1. As an equity investor with a long term, fundamental approach; I actually dont really know what an inverted yield curve is and I dont care to find out. Just like financial news, macro economics and a whole lot more, I just see it all as noise and distractions to my purpose and direction. It may be a naive or ignorant approach, but its my approach!

  2. This stuff is way beyond my expertise. But I do know that billionaire investor, Ken Fisher, has been making much noise, for quite a while now, about the need to think in terms of a "global yield curve". The premise is that in an era of fairly frictionless international capital flows, a bank in country A (which has high rates) can borrow from country B (which has low rates) and lend in its own country. In this respect, the shape of the curve, at the national level, is irrelevent.

    He proposes a global curve calculated by weighting national curves by GDP. It is possible then, that a positive sloped global could can exist (and I haven't checked to see if this is still the case) even if every nation on earth had an inverted curve.

    What I don't know, is how much of this international spread will be wiped out by the need for currency hedging.

  3. Love you like a brother LT, keep it coming...…

    More insight on life insurance companies too please....

  4. Your explanation of why the curve inverts makes a lot of sense. The other explanation would give institutions in the debt market near perfect recession predictive abilities, which does not seem likely.

    What do you think of the 'we are due for a recession because it has been 10 years' thinking? This line of thinking is also pretty analogous and it always kind of bothered me. My reasoning is, generally we get downturns because few are expecting it. That is the whole reason a recession happens, too many overly optimistic people borrowing too liberally. And banks letting it happen.

    Yet whenever you turn on financial media these days, all people talk about is how we are due for a recession. That does not seem like the type of climate that causes serious recessions...

    My theory in this is that internet and widespread social media has made information more sticky. It is now easier than ever to find information on what happened 10 or 20 years ago. Added onto the fact that we had two major bubbles in the last 20 years.

    How would you know about past excesses and learn to recognize it before the internet was a major thing? You had to buy a book on past crises and read it? Order videotapes by phone? Anything read on the internet did not really have much credibility before the last 10 years or so...

    Now you can open YouTube and watch videos and documentaries of 10 years back very easily. And there are loads of websites that are increasingly popular like zero hedge that try to predict the next crisis. Documentaries about these events are more widespread and watched than ever.

    And a lot of crisis predictors have risen towards hero status in a way that has not happened before. Correctly predicting Armageddon is just more sexy than predicting prosperity. And
    social media can more easily spread their message.

    Usage of social media:

    This increased stickiness can also make bubbles last longer though.

    1. Thanks for your comment.

      I completely agree that the argument we are 'due' a recession is a bad one. Australia has gone nearly 30 years without a recession. Expansions don't die of old age, as they say.

      The reality is that you need some sort of supply-side or demand-side shock to trigger a recession. Supply side shocks are rare, but can happen (e.g. 1970s OPEC oil embargo). Usually it's a demand side issue often associated with a sudden decline in the availability of credit.

      More specifically, one of the following has to happen: (1) consumers stop spending; (2) corporates stop investing; (3) the government stops spending (dramatic fiscal tightening/austerity); or (4) exports significantly decline. All of those represent a 'demand shock' that can trigger a recession.

      In the GFC, consumers stopped spending and investment also stopped - particularly housing construction (the word 'stopped' here is intended as 'sharply declined'). That's because spending was being driven by a housing bubble, and when it burst, consumers felt poorer and spent less, and housing construction fell for obvious reasons.

      Consumer lead busts are rarer than investment-led busts. Usually, overinvestment happens, it pushes down returns, debt distress emerges, banks curtail lending, and then investment drops. Overinvestment in telecoms infra for eg contributed to 2000s downturn. Railroad investment cycles contributed to many severe recessions in the 19th Century. As noted in the article, businesses have generally invested tepidly post GFC, and the only areas of overinvestment I can see in the US are shale and tech - the latter of which is equity funded. If the latter blows up it could lead to a recession, but it will have nothing to do with credit or the yield curve.

      Fiscal austerity is unlikely pre-election, and the US economy is not driven majorly by exports. It is unlikely US exports fall enough to trigger a recession (although the current global slowdown is hurting export-lead economies like Germany, Sth Korea etc, much more). Investment is slowing globally also due to trade war uncertainty, but I think such a slowdown will affect the US economy the least (and hurt China the most), as it will benefit from offsetting import substitution.

      It doesn't matter how long it's been since the past recession - one of these things has to happen for a recession to occur. On your final point, I think it was because the GFC was such a formative event for many of this generations' investors. Everyone is expecting (and trying to call) the next crisis. But crises are rare. My bet is the US doesn't fall into recession for quite some time yet.


    2. Hi Lyall, I'm a avid reader of your blog and my question is that it seems that your explanation may explain why the US may not be due for a recession , but other countries, most specifically in Canada and maybe Australia fit those 4 criteria almost perfectly. I can only write about Canada as I live here, but;

      1) Canadians are pretty much tapped out, they cannot depend on borrowing against their home equity to further consumption and wages have not not significantly improved in the last decade.

      2)Non-residential investment has been tepid at best in the last few years, with massive capex reduction in the natural resources industry.

      3) The government is kind of a wash, there hasn't been any major stimulus so far that I know of and a somewhat "relatively" hawkish central bank.

      4)Exports are in trouble with the trade wars and the glut of oil and minerals that Canada produces.


    3. Thanks for your comment. I agree that Canada, Australia, and NZ are the Western economies most likely to fall into a recession, as unlike Europe and the US, their long-term private sector credit cycles did not peak out in 2007, but have instead risen to new highs. These economies are very vulnerable.

      However, unlikely many European economies, they do have the advantage of having their own flexible exchange rates. The US also benefits less because having the world's reserve currency, the USD is less responsive to domestic developments (the USD strengthened during the GFC, for eg).

      One of the reasons Australia has gone so long without a recession is that when the country hits turbulence, the AUD tanks (much as it has recently), which creates a significant stimulus from rising AUD-denominated exports. It remains to be seen if currency weakness will be sufficient to offset domestic headwinds this cycle. I suspect more currency weakness than we have seen thus far will be required, and it will also depend on the level of commodity prices.


  5. Couldn't agree more. If everyone is worried that we are due a bear market, "because it's been 10 years", which clearly isn't causative (apart from creating sentiment), then the demand for stocks has to be lower than it otherwise would be.

    But people will still get up in the morning and go to work, and GDP will keep marching up. Eventually, then, people will likely lose this fear. That's why John Templeton's words, make much sense: “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria,”

  6. -If one is comfortable with a buy and hold strategy based on sound fundamental analysis, the inverted curve significance is likely to be nil.
    -Yield curve inversion may mean something though.
    -The last time around before 2007, yield curve inversion was dismissed by central bankers using similar arguments mentioned above.
    -Thinking by analogy can be a very useful tool especially when there are many variables within a complex system.
    -There are criteria that may help to validate the predictive power of the phenomenon and its significance: false positives, false negatives, chronological relevance, coherent explanation, causality vs correlation or else.
    -The spread between the 3-month Treasury bill rate and the yield on 10 year or longer-term Treasury bonds has inverted for the 11th time since 1921. In all previous ten inversions, recessions followed.
    -Inversion may perhaps be seen as a constellation of coalesced economic manifestations that cannot be masked by artificial management of interest rates and that point to weaker credit growth and slowing economic growth.
    -For instance, if one were to build an artificial intelligence program that would predict for rain, one would weigh and coalesce various significant variables and would also use manifestations that reliably englobe other variables. Have you tried to obtain insurance coverage with a sophisticated broker? The broker will come up with a precise and reliable estimate of the premium, even for complex coverage, after a few simple and sometimes apparently unrelated questions that capture the essence of a specific risk.
    -Since the GFC, on a net and global basis, deleveraging has not occurred, in fact quite the opposite.
    -If you think that lower growth rates, weaker recoveries, rising debt levels have a common set of explanation and that the GFC was just a prelude, another curve inversion may mean that the buy and hold for the long term may be about to be tested.
    -Mr Gundlach (bond king) has commented that, if anything, with ultra-low interest rates, yield inversion may even be more significant than before.
    -Japan is leading the way in our surreal negative rate environment and has seen its flat curves getting flatter and, lately, this has given rise to more reaching for yield behavior that suggest that a lower bound has been reached:

  7. Thanks for the post - I agree that a primary causal link between the yield curve and recessions is likely the bank credit channel. However, I also wonder whether financial conditions could tighten enough, simply driven by fear/sentiment, to cause the yield curve inversion to become somewhat of a self-fulfilling prophecy (obviously something very difficult to predict).

    On another note - what is your preferred way to incorporate recessions into security analysis and valuation?

    1. In terms of the chicken or egg question (what comes first), who knows but common sense would seriously question that yield curve flattening or inversion actually causes recessionary conditions. An interesting study about this aspect comes from the SF Fed and is quite recent:

      If one comes to the conclusion that this is relevant now, a way to make sense out of all this is that the financial system which is now global, ultra-connected and somewhat correlated has not been able to sustain even mild restrictive conditions (US Fed timidly raising rates and timidly starting to normalize its balance sheet in 2017 and 2018), suggesting an explanation for the flattening and suggesting that we are only at half-time after what started with the 2007-8 episode and in the midst of the greatest global monetary experiment of all times.

      On a personal note vs incorporation of recessions into analysis, it seems that this is a worthless activity perhaps 95 to 99% of the times but I would submit that this time is different. :)
      The most relevant "analogy" may be what John Law tried to do at the beginning of the 18th century. Perhaps a first principle conclusion is that analogies can be sometimes useful when so-called sophisticated people in charge try to apply a solution to a problem without trying to really understand what caused the problem in the first place.

  8. Random question for you Lyall, how do you track the research done for any investment? Since your style is both very active and very wide spread holdings. Do you use stuff like Evernote or something more industry specific?

  9. thanks for the great article.
    Got a silly question though: How is it possible to have loan to deposits ratio higher than 100%?