The TRUTH about the Inversion and Coming Recession.

hey everyone kevin here so are we going

into a recession almost every youtuber

or financial media outlet is saying

that's it the 10-2 has inverted and

don't worry if you don't know what that

means i'll give a brief explanation on

that and they're saying that's it we're

definitely going into a reception

circle the wagons because folks there's

nothing we can do anymore every single

time in the past that the 10 year and

the two-year treasury curve has inverted

we've been screwed and we've ended up

going into a recession

but there are three things that can

actually explain an inverting yield

curve one could be

the fed has lost all potential faith by

markets

number two could be we are going into a

recession and number three could be

this is what you would expect to happen

in this market and then of course

they're going to be hints and tools that

we could use to tell us which one of

those three scenarios is likely to play

out that is is is this just a sign that

people don't believe the fed anymore is

this the sign we're going into recession

or

is this what you would expect to happen

so let's break this down

first and foremost when we consider the

10-year and the two-year yield curve we

have to understand what those things

individually represent first and

foremost if you had ten thousand dollars

and you said to the government hey i'm

gonna give you ten thousand dollars just

pay me interest

while i lend you that ten thousand

dollars and at the end of let's say ten

years for a ten year treasury bond give

me my ten thousand dollars back

and the way this would work is

you take about ten thousand dollars and

the government might say hey we'll pay

you two and a half percent or two

hundred fifty dollars per year for ten

years which is great because that's two

thousand five hundred dollars and that

would mean that you have earned two

thousand five hundred dollars on top of

your ten thousand dollars for ten years

now you can buy and sell this bond but

basically that's what the the ten year

bond is right

if you get two and a half percent for

the ten year then what if you only

agreed to lock up your money for two

years well you would expect to get paid

less money maybe only 180

per year for two years because at the

end of those two years you could take

your ten thousand dollars back and you

could go do something else with it right

so you would expect to get less money

because you're taking less market risk

locking your money up for less time

again you can buy and sell these bonds

but if you don't hold them to duration

you're subject to market risk and that

means if other people all of a sudden

are selling the two-year bond like crazy

the value of your bond if you were to

sell it plummets and that's really

really bad if you're holding that

two-year bond right

so assuming you want to hold these two

duration the full term you would then of

course expect that maybe a one year

would only pay you like one percent

because again you're taking less risk so

you would expect to get paid less

so why why would it then make sense ever

for potentially instead of getting paid

two and a half percent on the 10 and one

and a half or 1.8 percent for the two

why would it ever make sense

for all of a sudden the 10-year yield to

be 2.5 per year and let's just say i'm

going up a little bit higher than what

is actually happening right now let's

say the two years paying you

three percent why would that make sense

that you're getting paid three percent

for the two year and only two and a half

percent for the ten

would make sense if you want the value

of your bond to maintain some value over

the next two years and you're investing

in two-year bonds during a time in which

other investors are actually selling the

two-year bond because if you get a lot

of people selling the two-year bond

that's going to lower the price of that

bond and anybody holding that two-year

bond is going to lose money if they want

to trade it people don't want to lose

money so in other words people right now

in the market are having to be

compensated a higher amount in order to

take the risk on the two-year bonds so

why is that well there are a few reasons

and the big predictor tends to be okay

well when the two-year is getting paid

more in yield than the 10-year and

that's a sign that we probably have a

bad market coming up within the next 12

to 24 months right i mean look at the

past times that the yield curve has

inverted

we had an inversion right before the

paul volcker era right in the late 1970s

and early 1980s we had some ugly

recessions in both circumstances here in

fact on st louis fred we see two plotted

recessions demarked by those gray bars

you see the inversion here in about

88.89 at a recession right after that in

the early 90s you see an inversion over

here in about 2000 and of course the

dot-com bubble recession another

inversion over here in about 0-6 and

what do you get the great recession you

get an inversion over here in 2019 and

oh my gosh sure was a pandemic caused

recession but he's still at a recession

so here we are again inverting again

that

makes us feel like looking at just this

chart that crap this is a sign the

market is pricing in that we can have a

poopy-doopy economy in a year to 18

months to a year and a half and people

who are investing in two-year bonds want

to be compensated more

for taking that risk okay so because if

we're in a recession bonds will probably

sell off stocks will probably sell off

so that makes sense we probably aren't

able to anticipate that we'll be in a

recession in 10 years right so we're not

going to go out to the 10-year and all

of a sudden demand much more money for

that because we think we'll be through

whatever turmoil we're right now so

that's usually how the 10-2 works but

wait a minute wait a minute

what if

the reason we're seeing the two-year

demand such a high premium is because

we're actually on an aggressive interest

rate hiking path

what that means is we believe

that interest rates are going to be

about two percent by 2023 so let's

actually write down that right now in

2022 and q1 2022 we're at 0.25 for the

fed's interest rate but what if in

q

uh 1

2023

interest rates are actually at

2.25 and then in q1 at 2024 interest

rates are three percent well if those

are what the fed's interest rates are

then you better be demanding a big fat

premium for those two year bonds

but wait a minute do we actually think

the fed's going to have rates this high

this long

no in fact most estimates say that by q1

2025

we're actually going to see those

interest rates maybe come back down

maybe back down to two percent where the

fed relaxes the interest rate hiking

cycle assuming that eventually the

supply chain issues repair themselves

and inflation goes down

so in this dynamic if we actually draw

this out let's draw this we're very very

low right now

we're going to go very very high within

about two years

then we'll probably begin a loosening

cycle and head back down

and what's very interesting about this

is

close to us that is like the closest

bond we could get to us is going to be a

really short-term bond right like maybe

a

three-month bond right

the one that probably aligns most with

the peak of the fed's rate hike cycling

uh rate hike cycle

is the two year which means the one that

has the most market risk

is the two year and the 10-year or even

the five year are probably way way way

out there at the end of the curve right

let's just go with the tenure for now so

now

you realize based on the fed's rate hike

cycle that you're going to have to

demand a big big big premium in interest

rate for that two year because you're

going to be having that two year

at a time when the market if you needed

to sell this bond has high interest

rates and the value of your bond could

be very very low if again remember this

if you lock in a bond a two year bond at

two and a half percent but the fed's at

three percent well the two-year bond on

the market might actually be trading for

like three or four percent interest that

means yours at two percent is worthless

like literally worthless you're taking a

lot of market risk right

so this is interesting because in the

prior chart we saw that a recession is

always

predicted by this 10-2

but

if we now consider have we had an era

where the 10-2 has inverted

during which time we also expected in a

really weird way

that interest rates would go up for a

couple years peak and then come down see

in the late 70s we thought inflation was

entrenched that inflation was going to

stay forever and we had to go through a

nasty recession to actually get that

inflation out but the market's actually

pricing in to some degree that the fed's

going to be right then that inflation's

going to come under control

but wait a minute let's go back to those

those three things that i mentioned

could happen

number one we could have a recession

that is a proper

predictor of the 10-2 right

we could also have a loss of faith in

the fed

god of faith

and

we could have normal market dynamics

so while i wrote this a little bit of it

out of order we talked about number one

the chart showing we should be seeing a

recession right we actually also talked

about number three that it would make

sense that you're demanding a higher

rate for the two year given the fed's

rate height cycle path

but what about the third potential well

the third potential is this the chart

here that

fed rate hike cycles

that don't end in recession are actually

quite rare that is almost every time the

fed raises rates over here in the early

70s over here in the early 80s

over here in the late 80s over here in

the

dot com era over here in the great

recession period and of course over here

uh and going into about 2018-19 ended up

leading to that 2020 recession right

those are all instances where the feds

started hiking and at some point we hit

recession interestingly we usually hit a

recession when the rates kind of start

trending down or when the rates peak

which is very interesting like you see

that right before 08 that sort of peak

you see that right before the dot-com

era you see that right before the 89

recession so it's almost like the fed

has to

go to its go through its rate hike cycle

during the rate hike cycle the economy's

still growing like crazy it's actually

still growing great that's why they're

hiking because we're almost growing too

fast

they stop hiking and it's the point when

they stop hiking that you're actually

potentially closest to a recession

because that's when they're like oh okay

yep we're achieving our goal we're

slowing the economy ah crap we slow too

much recession now there have been two

cases over here in the mid 80s

and uh over here in the mid 90s where

the fed was able to do what's known as

have a soft landing to stick the landing

to raise rates

and then lower them without having a

recession it's just more rare than not

and so that's potentially why markets

are saying yeah now ten two is inverting

because we are going to see a recession

so if we go back to this chart over here

or this right down here this loss of

faith in the fed and recession this is

almost one and the same the markets are

saying uh yeah no we're going to have a

recession

but

it also entirely makes sense

based on the fed rate hike cycle path

this time that normal market dynamics

would invert the ten two curve and that

yes i hate this phrase but yes

this time could be different but wait a

minute we don't just want to be blind

and say oh this time could be different

i mean come on like when we talk about

this kind of stuff in our courses i

always talk about hey you've got to have

your eyes open to all the potential

different scenarios and the indicators

that would tell you which path that

you're on and so let's try to understand

which path we're on now and how that

maybe compares to different paths paths

and this is what you've got to pay

attention to

inflation

expectations that's it i know that

sounds crazy but there are two ways you

can measure this one you measure

inflation expectations by consumers

number two you measure inflation

expectations by looking at the five year

treasury break even if the line on the

five year break even is going down that

means inflation expectations are going

down the last week they've actually been

going down

the inflation expectations for consumers

are ironically anchored right now they

were not when we got paul volcker

and

remember going back to this chart right

here how i told you that the three month

would probably not see as much of a

premium as the two year

here's another curve that you could pay

attention to

it's called it's also another recession

indicator and it's on this chart right

here it's called the 3

10 yield look at this

all of the curves are inverting the 5's

tens the twos tens the tens thirties

like all these longer term ones are

showing some form of inversion

but what's this

a very popular predictor of recession

the three month tenure is actually not

predicting a recession in fact it's

going entirely the opposite direction

why folks well because

this curve right here

this path that we're on of rates going

up

and then rates expected to come down

we haven't seen before in the past we've

seen inflation expectations out of

control

we've believed that oh no the fed's

gonna rate uh hike rates and then

they'll never come down again

but now the market's already pricing in

this decline

and so in other words

we pay attention to that three-month

tenure we pay attention to the inflation

expectations and yeah the inversions and

the other curves might deepen

but some of these inflation expectations

remain anchored

maybe

maybe there's a chance we can actually

avoid a recession so again pay attention

to inflation expectations by consumers

by inflation expectations in the market

by the five-year break even and then of

course pay attention to a wage price

spiral possibly happening last labor

report said again no wage price spiral

4.8 percent year over year or my month

over monthly annualized right big deal

and

uh number four of course cpi month over

month so we gotta pay attention to all

of this anyway thanks so much for

watching we'll see you next time