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For nearly two years, the curve was inverted - meaning short-term borrowing costs were higher than long-term ones. Normally, long-term rates should be higher because investors demand more return for lending their money over a longer period.

But an inverted yield curve flips this dynamic, which has historically been a red flag for a potential recession.

In fact, an inverted yield curve has predicted a recession 9 out of 10 times in the last 70 years, according to Deutsche Bank¹.

Why is this such a problem?

Well, banks typically borrow money at short-term rates and lend it out at long-term rates. When short-term rates are higher than long-term rates, their profit margins shrink, making it harder for them to operate effectively. As a result, loan growth slows, and that ripple effect hits the broader economy.

• The FDIC’s May report² showed banks’ profit margins fell to 3.17%, down from a pre-pandemic average of 3.25%. Rising competition for deposits pushed up costs, while returns on loans shrank.

Think of it this way: the bond market (the crowd) sets long-term rates based on what they think the future holds for the economy. The central bank, like the Federal Reserve (a handful of bankers), controls short-term rates to guide what’s happening right now. So, while the bond market looks ahead, the Fed is focused on the present.

Why the Inversion Matters 

So, why does this matter? Because I believe our post-1980 economy is heavily reliant on credit.

Easy access to credit fuels spending, investment, growth, and even government funding. Thus, the more credit-dependent the system, the more sensitive it is to interest rate changes.

This is why when the yield curve inverts, it often sends waves of ripples. Banks get squeezed, loan growth slows, investment drops and people lose confidence. This leads to weaker spending and slower economic growth, which causes federal deficits to spiral.

What Just Happened: The Yield Curve Normalized

This week, we saw labor market data soften - job growth in August hit a 3.5-year low³ (three-month payroll growth slows to lowest since mid-2020), and the broad unemployment rate (U-6 rate) rose to 7.9%⁴. As a result, short-term yields fell below long-term ones, and for the first time in over two years, the yield curve “normalized.”

Because of this, the yield curve is steepening again - and that’s where the real concern lies.

There are two ways this happens:

1. When growth and inflation rise, the market demands higher long-term yields to lend money. However, this has been rare in the last 40 years.
   
2. When the central bank cuts rates during a recession, narrowing the gap between short- and long-term yields. This is the most common cause of steepening.

When the yield curve steepens because the Fed is cutting rates, it usually signals that the central bank is “behind the curve” and scrambling to catch up as the economy deteriorates.

Take a look at the data: Since 1990, every time the 10yr/2yr curve normalized (when the blue line goes above zero), a recession wasn’t far behind (shaded area).

Figure 1: St. Louis Federal Reserve, September 2024

So, it’s not the inversion that’s the biggest warning sign - it’s the un-inversion that signals real trouble ahead.

The U.S. labor market, despite the headlines, is still struggling. Job openings are at their lowest since early 2021, layoffs are increasing, and consumers are quickly falling behind on debt payments. Manufacturing is also slowing at a rapid pace⁵.

This dip in labor demand and consumer health along with a shaky stock market leaves the Federal Reserve in a tough position: should they keep rates high to fight above-trend inflation, or ease up to support a weakening economy, risking sending prices higher?

Well, it looks like they’ve decided.

At the recent Jackson Hole conference⁶, Fed chair Jerome Powell made it clear that the Federal Reserve would cut interest rates on 18 September, stating that "the time has come for policy to adjust. The direction of travel is clear.”

The Fed’s more worried about the decelerating economy than overheating at this point. And that's why shorter-term rates are declining as the market prices that in.

Three Big Things To Keep In Mind

We’ve all heard the phrase, “This time is different,” and it’s usually not a good sign.

But in the interest of staying balanced, I can’t help but wonder - maybe this time really is different? Here are three major reasons we might actually be treading new waters when it comes to the yield curve as a tell-tale recessionary signal.

1. The Global Savings Glut – Put simply, there’s just too much money chasing fewer yielding assets.

Imagine a town where everyone starts saving lots of money, but there are only a few businesses to invest in. Instead of stuffing their cash under a mattress, they all want to put their money to work by investing in those businesses. But with so much money and so few opportunities, businesses don’t need to offer high rewards to attract investments anymore. So, the returns on those investments (like interest rates or yields) get smaller and smaller because there’s more money available than places to put it.

Just like that town, in the global economy, there’s a huge amount of money - coming from pension funds, insurance companies, banks, surplus countries, and billionaires - all looking for investments (like bonds). But because the world isn’t offering enough high-yield opportunities, all that money ends up chasing the same few safe assets, driving yields lower. That’s why we call it a "savings glut."

I'll dive deeper into this in an upcoming Morning Pour, as it’s a big-picture theme that the mainstream tends to overlook.

2. Changing Market Expectations – Sentiment has shifted. Many now believe the economy can withstand higher interest rates, reducing fears of an immediate recession⁷.

But be cautious - sentiment can flip fast, like a cat going from purring to biting. Markets are social systems, and if enough people believe something, it can become a self-fulfilling prophecy. I don’t think the credit-driven economy can handle high rates for long without something breaking. Eventually, sentiment will shift from optimism to fear.

3. Drunken Government Spending – The U.S. government’s massive deficits distort the yield curve. See, when the U.S. runs deficits (which have been enormous), it borrows more by issuing debt, thereby increasing the supply of debt.

• For instance, the U.S. federal debt has surged by more than $12 trillion in just four years - a roughly 50% increase - and marks one of the most rapid expansions in U.S. history.

Figure 2: St. Louis Federal Reserve, September 2024

Normally, this would push yields higher (too much debt fighting for fewer dollars). However, strong demand from both domestic and international investors for safe assets like Treasuries keeps long-term yields low, flattening or inverting the yield curve despite the higher supply.

It gets even more interesting because some experts think the U.S. Treasury might be changing the way it issues debt to help the economy and protect banks.

Two economists - Stephen Miran and Dr. Nouriel Roubini - recently published a paper⁷ arguing that the Treasury is focusing more on flooding the market with short-term debt (Treasury bills), which have higher interest rates, than cheaper long-term debt (like bonds). This has kept long-term debt rates lower, thus making it easier for people to borrow and spend (or as they call it, it's a stealth stimulus). 

To put this into context, the chart below shows how much of the government's new debt is in short-term Treasury bills.

Figure 3: Hudson Bay Capital

Typically, the government issues more of these bills during tough times, like in 2008 and 2020 when the economy was struggling and interest rates were falling.

But now, they're issuing a lot of short-term debt again, even though we're being told the economy is "doing well." This raises questions about why the government is making this choice, especially with short-term rates currently much higher than longer-term ones.

• I'd take it one step further by saying this also greatly helps banks because if long-term interest rates go up further, banks could lose more money on their bonds (and they’ve already lost over $500 billion on paper so far).

Figure 4: FDIC, May 2024

It's important to note that the Treasury Secretary, Janet Yellen, has denied these claims - telling Bloomberg, “I can assure you 100% that there is no such strategy.”

As Always, Just Some Food For Thought

Anyways, at the end of the day, the yield curve is normalizing.

And whether this signals trouble ahead remains to be seen.

Personally, I believe it does.

Either way, it’s definitely something to keep an eye on.

Take care.

Sources:

1. US yield curve nears flip with jury out on recession signal | Reuters
2. FDIC Quarterly Banking Profile First Quarter 2024 | FDIC
3. US Companies Add Fewest Number of Jobs Since 2021, ADP Data Show - Bloomberg
4. US Hiring Comes Up Short in Possible Warning Sign for Fed - Bloomberg
5. Are We Already in a Recession? Labor Market Signals an Economic Downturn | Dunham
6. Central banks to step up the pace of rate cuts later this year | articles | ING Think
7. Activist_Treasury_Issuance_-_Hudson_Bay_Capital_Research.pdf (hudsonbaycapital.com) 

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