· The aftershocks of the taper tantrum in the middle of the yield curve are now spreading to the rest of the yield curve and, eventually, will spread to the rest of the economy (Chart 1). The initial effect of the taper tantrum was to break the yield curve in half – causing the front half to steepen and the back half to flatten. The recent aftershocks have partially reversed the yield curve divergence (Chart 2).
· Market commentary has fixated on the inversion of the back half of the yield curve and the usual debate about “this time is different” is in full swing (Chart 3). The confusion is driven by a misunderstanding about the difference between an indicator and a rule of thumb. Rules of thumb are for use when direct causality cannot be measured or is too complex for a single measure. In contrast, an indicator is a direct measure of a factor that causes people to act.
· The yield curve is an indicator because, among other things, it determines the profit available to lenders for providing maturity transformation. Banks will only take the risk of borrowing short-term funds and lending them for a longer maturity if they are properly compensated.
· In recent decades, the Fed responded to deteriorating economic conditions by steepening the yield curve to incentivize lending (Chart 4). Unfortunately for the Fed, the taper tantrum they kicked off in March flattened a key portion of the yield curve just as consumer sentiment was deteriorating (Charts 5 & 6).
· Worse still, the inversion is being driven by movements in real interest rates rather than simply changing inflation expectations (Charts 7 & 8). If it were only the nominal yield curve flirting with inversion one could blame temporary distortions caused by market frictions. The real yield curve has a direct effect on economic plans and recent flattening will result in economic slowdown later in the year.
· Note that the relationship between the oil/gold ratio and the 10-year Treasury remained stabled even as prices moved suddenly when war broke out in Ukraine (Chart 9). In contrast, the relationship between the price of gold and real interest rates has been muddled recently (Chart 10). Expect more volatility in real yields as crosscurrents and a confused Fed muddle through 2022. The result will be a very volatile, though not necessarily higher, gold market. Plenty of trading opportunities if one can stomach the risk.
Stocks to Watch: AZO, CTVA, DAC, DDS, ET, K, MO, PM, TU, WMB, X
Keep reading with a 7-day free trial
Subscribe to Capitalist Pig Collective to keep reading this post and get 7 days of free access to the full post archives.