The Breakdown - The Market Indicator Flashing ‘Recession’

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.io, Arculus, and FTX, and produced and distributed by CoinDesk. What's going on, guys? It is Wednesday, March 30th, and today we are discussing about the economic indicator that is flashing recession and how much stock we should put in it. First, however, if you are enjoying the breakdown, please go subscribe, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure as always, in addition to them being a sponsor of the show, I also work with FTX. And finally, one more thing.

Starting point is 00:00:57 If you haven't bought your tickets yet, I highly suggest you check out CoinDesks Consensus 2020. which this year is happening in Austin, Texas, between June 9th and June 12th. The event has voices and topics representing a huge cross-section of the crypto space. You've got your ZZs and SBFs, but also Punk 6-529 and Kathy Wood. It should be a really, really good time. If you're interested, you can use code breakdown for 15% off your ticket. Check out coindesk.com slash consensus 2022. All right, well, there is a lot we could be talking about today.

Starting point is 00:01:33 We've got recent comments from Doe Kwan, from Terraform Labs, a follow-up to what we were recently talking about, where he's discussing why he wants their project to buy so much Bitcoin, to have U.S.T. connected to the fate of the industry as a whole, to be the single biggest holder outside of Satoshi themselves. Now, this line of discussion has actually caused some to ask even more questions about this. Ryan Sean Adams from the Bankless podcast tweeted, is Terra UST the future of crypto money or a ticking time bomb waiting to explode? So clearly there is more that we could be discussing there. There's also this whole Greenpeace ripple thing,

Starting point is 00:02:15 which is just so disingenuous and gross that it's honestly going to take me a couple days to figure out exactly what I want to say around it versus just hitting my head against the microphone for about 20 minutes. I'm planning currently on addressing it on the weekly recap, but I don't have the energy yet to do. justice here. So instead, we're going to focus on the talk of the macro town, which is the big economic signal that is flashing recession. Yes, we are talking about yield curve inversion. From Bloomberg yesterday, bond market flashes recession signal as key yield gap inverts. The U.S. two-year

Starting point is 00:02:53 yield briefly exceeded the 10-year Tuesday for the first time since 2019, inverting yet another segment of the Treasury curve and reinforcing the view that Federal Reserve rate increases, may cause a recession. So let's try to break this down because I guarantee that this is a term that you're hearing a lot right now. First, what is the yield curve? The yield curve is the chart that shows the relationship between the yield of all treasury bonds. Treasuries are the U.S. debt notes and they come in various maturities. They come at monthly intervals and then one year, two year, 10 year, 20 year, and 30 year. The yield curve plots these yields against one another and in general slopes up. Why does it slope up? Well, in a healthy market, investors would want more compensation

Starting point is 00:03:37 for taking on a longer-term obligation. Taking on a debt note for 10 years should be more expensive to the borrower than taking on a debt note for two years. More specifically, investors expect to get more for taking on the risk that rising inflation will lower the expected returns of those longer-dated bonds. So when the markets are discussing the shape of the yield curve, they tend to be specifically interested in the spread of the yield of the two-year and 10-year bonds. When the curve is steepening, it's a signal of stronger economic activity and growth. When it's flattening, it suggests that investors are losing confidence in the economy's outlook for growth. When it inverts, in other words, the yield on the short-duration bond is higher than the long-duration

Starting point is 00:04:17 bond. It's one of the most damning indicators of confidence in the markets. It suggests that market actors have significantly diminished confidence in long-term growth. It suggests that market actors, it suggests in other words, that short-term economic prosperity is not likely to hold or is likely to decline. Here's another explanation from Terek Mansour from Twitter. An inverted yield curve means that short-term rates are higher than long-term rates. The 210 spread turns negative. It means that lenders are charging lower for a 10-year loan than for a two-year loan. Doesn't make much sense, unless lenders think you are more likely to repay later than in the near future. They think you're going to get into tons of shenanigans in the short term. You probably guessed shenanigans equal

Starting point is 00:04:57 recession. The actual dynamics of how the longer-term yield falls are actually a bit more complex. It's about supply and demand. Let's say that you, as an investor, think shit is going to hit the fan in the next few years. Shit hitting the fan equals recession equals S&P might go down or stay flat. Invest in S&P? No. Invest in bonds? No. Invest in bonds? Well, the short-term situation looks bad. Invest in two-year treasuries? No. How about long-term? It looks decent. Even if there's a recession, we'll probably get our shit together within 10 years, and if we don't, then who cares, we're screwed anyways. Longer term looks good.

Starting point is 00:05:30 Invest in 10-year treasuries, yes. Demand for two years down, price down, yield up. Demand for 10 years up, price up, yield down. An age-old economic chorus. Sing it with me, supply, and demand. So if that's a bit of an explanation of what a yield inversion actually is, what really matters and why everyone's discussing it is that historically there is a relationship between yield curve inversion

Starting point is 00:05:54 and recession. Between 1955 and 2018, the yield curve in the U.S. has inverted before each recession. Recessions followed between six and 24 months later, and only once in that period did it offer a false signal, and that was in the mid-1960s. One historical researcher looked even farther back. Since 1900, there have been 28 instances of the yield curve inversion, 22 have seen a recession, and six have not. The lag between inversion and recession has averaged 22 months, but ranged between six and 36 months over the last six recessions. The last time we saw an inversion was 2019, and we did, in fact, have a recession the next year, but obviously that had some major exogenous causes that makes it a harder to parse signal

Starting point is 00:06:36 relative to the rest. Nexto is the go-to platform for all things crypto. Invest in the hottest coins out there and start earning risk-free interest of up to 20% APR, paid out daily. Need cash ASAP, but don't want to sell? Use your crypto as collateral and receive a credit line at premium rates. Open your NXO account by March 31st and receive up to a $100 welcome bonus. Get started today at nexo.io.

Starting point is 00:07:10 That's N-E-X-O.io. Meet Arculus, the next-generation cold storage wallet. Arculus secures your crypto using three-factor authentication, providing a simpler, safer, and smarter way to store, buy, swap, send, and receive crypto. Arculus is offline cold storage. Your private keys are encrypted on the Arculus keycard and are never online. Stay safe from hackers with no cords, no charging, no Bluetooth. Just crypto security made simple.

Starting point is 00:07:43 Buy Arculus on Amazon today. The breakdown is sponsored by FTXUS. FtXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets, with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transactors. fees and no withdrawal fees. One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs.

Starting point is 00:08:12 When you trade NFTs on FTCS, you pay no gas fees. Download the FTCX app today and use Referral Code Breakdown to support the show. So what is driving this particular inversion? Well, it's a couple things. First, short-term yields are rising, reflecting expectations of rate hikes coming from the Fed. Second, the longer-dated yields aren't moving at the same pace, and the thinking among many is that this is the bond market signaling that they believe that the short-term policy of rate hikes is going to actually hurt the economy in the long term, slower growth, etc.

Starting point is 00:08:45 But differently, the Fed will likely be required to reduce rates once again. Now, if that's what markets are anticipating, it's worth asking what this actually means to the real economy as well. The Fed hiking its rate means that the cost of borrowing is going up. Banks in the U.S. use benchmark rates to determine how much they're going to charge for the loans that make average consumer life work, small business loans, mortgages, credit cards, auto loans, etc. The whole idea of the Fed using rates to combat inflation is to slow down economic activity by making borrowing money more expensive. But of course, that comes with consequences

Starting point is 00:09:21 too. Yield curve inversions don't just matter in terms of their signaling either. They have practical impacts for banks who provide liquidity to financial markets. Banks make money by borrowing short-term at low rates and lending longer-term at higher rates, the difference between those two being their profit. When the curve flattens, the difference decreases and so too does their profit, which means less lending and less liquidity to the market as a whole. Now, as I mentioned, this has been the main source of chatter, certainly on FinTwit. Lisa Abramowitz at Bloomberg writes, the gap between the two-year and 10-year treasury yields falls to a new post-2019 low of less than eight basis points. Even if there's an end to the war in

Starting point is 00:09:57 Ukraine, it's unlikely to bring a rapid end to sanctions, food, and supply chain disruptions. This is the concern for some analysts. Jim Bianco writes, the 10-year two-year curve is now less than seven basis points away from inverting. 71% probability of a 50 basis point hike in May, 21% probability of a 75 basis point hike in June. 10 rate hikes in 2022. The Fed hikes 75 at the November 14th-1994 FOMC meeting. It has precedent. The cycle has worked in the following manner. The market first begins to price in a hike, but the odds remain below 50%. Everyone laughs. The odds of a hike raised to 50%. Everyone forecasts it won't happen. The odds rise to somewhere around 66% and everyone starts to wonder.

Starting point is 00:10:39 The odds rise to 75% to 80% and Goldman forecasts it and everyone else on Wall Street follows suit. Are we at the Everyone Laughs phase of a 75 basis point hike? Will the rest of the cycle follow by June? Some of the commentary was about breaking out of overly simplistic recession or not kind of thinking. Cullen Roche tweets, The yield curve is officially inverted, some thoughts on what this might mean. One, yield curve inversions have preceded every recession in the last 60 years.

Starting point is 00:11:05 Two, recession usually occurs 12 to 18 months after an inversion. Three, there is mixed evidence of this indicator's utility outside of the USA. Four, curve inversions usually precede disinflation, a.k.a. falling rates of inflation. My personal view, developed economies are highly interest rate sensitive as they're so financialized. So the yield curve is a coincident indicator that tells us a lot about the probability. of future growth. But it's not an on-off growth switch. One thing that the curve appears to

Starting point is 00:11:31 be signaling is that there is a rising risk of a Fed policy mistake, i.e., the market is less worried about inflation while the Fed is potentially reacting too much too fast or too late. In short, an inverted curve doesn't automatically mean the world is ending or that recession is imminent, but it does tell us that the probability of the economic slowdown is rising. Stay tuned, a much deeper inversion would warrant much more attention. Now, there are other measures too that may be more or less suited to determining whether we're headed towards a recession. Fed Chair Jerome Powell, for example, recently said that his preferred recession gauge is to look at the three-month treasury bill rate and then the market pricing of derivatives predicting the price for that same rate

Starting point is 00:12:09 18 months later. Scanda Armagnant, the executive director at Employ America, also puts a different measure as is preferred. An inverted yield curve reflects the expectation of future Fed cuts, which is related to but also not equivalent to recession risk. Don't treat it as fate, but don't dismiss it with a this time as different excuse. Credit spreads and equity risk premiums are a better proxy for recession risk than an inverted yield curve, in my opinion. Now, what Scanda's referencing that this time as different excuses are also all over the place. There are many people out there that are trying to argue that there are too many new factors for this to be a reliable indicator anymore, such as the Fed's purchase of trillions of dollars of bonds during the pandemic. In the Washington Post,

Starting point is 00:12:49 John Authors writes, the rise in the two-year yield reflects investor confusion in trying to deal with a situation that has no precedent in the working lives of most traders now active. Just as the Fed now admits that it has been behind the curve, so investors have been slow on the uptake and may now be overcompensating. That suggests that a curve inversion here should be treated with some caution. However, then there's skepticism of the skepticism. Bond King Jeffrey Gunlock tweets, Treasury yield curve spreads now. 10-year minus two-year, three basis points. 30-year minus five-year, zero basis points. Right on Q the, it doesn't matter this time. white papers are coming out. Don't believe them. And then on top of all this, there is the buy-the-dip

Starting point is 00:13:30 crowd. In another piece in Bloomberg called Don't Get Too Gloomy or Risk Missing Out after Yield Inversion, the author writes, for all the grim treasury market warnings about the economy, history shows that stocks and bonds tend to do quite well in the window between yields flip-fopping and U.S. recessions. Now, their source is a Piper Sandler study going back to the mid-70s. The broad stock market appreciates between inversions and the onset of the subsequent recession, With the exception of the Volcker years, fixed income assets always appreciated, with mortgages, investment-grade corporates, and Munis as top performers. Ryan Detrick from LPL Financial makes a similar point.

Starting point is 00:14:04 The last four times the 210 yield curve inverted, S&P 500 up an average of 28.8% before the peak, ultimate peak was 17.1 months later. Recession started 21 months later. Yes, it's a warning, but it isn't so simple. And then there were the folks who were having a laugh at this line of thinking as well that we had some knowable window of time that the good times could roll on. Bugo Capital tweets, told my boss the yield curve inverted today.

Starting point is 00:14:30 Let him know we only have two years left to be businessmen. Then it's all over, done. We cried for a bit and then said thank you to each other for all our hard work over the years. Still hard to acknowledge it will all be over soon. Now, I think the point that you're hopefully getting here is that there is a lot of history, a lot of precedent, but also a lack of clarity on what it's actually going to mean. This time, as in each of the past times, there are all. all sorts of new factors that could make things work differently this time. However, ultimately,

Starting point is 00:14:58 the entire media complex around the markets and the entire markets themselves are meant to answer these questions. If you are sure about the answers, you should definitely go express that confidence in a financial bet. But in the meantime, hopefully this has given you some more tools to figure out what you think it means. For now, I want to say thanks again to my sponsors, nexo.io, Arculus and FTX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.

Starting point is 00:15:31 Hey, breakdown listeners. Come join CoinDesk's Consensus 2020, the festival for the decentralized world this June 9th through the 12th in Austin, Texas. This is the only festival showcasing and celebrating all sides of blockchain, crypto ecosystems, Web3, and the Metaverse, and is designed for crypto-newbies,

Starting point is 00:15:51 investors, entrepreneurs, developers, and creators. Don't miss speakers like Kathy Wood, SBF, CZ, Punk 6529, and Joe Lubin to name just a few. Use code breakdown to get 15% off your pass at coindesk.com slash consensus 2022.

The Breakdown - The Market Indicator Flashing ‘Recession’

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.