Episode 48

Inflation, Rates, and Recession – The Worsening Inversion Version

By:

Senior Market Analyst at Interactive Brokers

Joe Burke, IBKR’s head of fixed income, helps us arrive at a clearer picture of yield curve inversions, what they might mean, and their relationship with economic recessions. And now that the Federal Reserve’s tightening of monetary policy is well underway, what is the worst that can happen in the fixed-income markets, and how can investors prepare?

Note: Any performance figures mentioned in this podcast are as of the date of recording (November 16, 2022).  

Summary – IBKR Podcasts Ep. 48

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Steven Levine

Hello, and welcome to IBKR Podcasts. I’m Steven Levine, senior market analyst at Interactive Brokers, and your host for today’s program. We’ll be speaking with Joe Burke, IBKR’s head of fixed income, to help us arrive at a clearer picture of yield curve inversions, what they might mean, and their relationship, or correlation, with economic recessions.

Welcome Joe, great to have you here with us, again!

Joe Burke

Thanks, Steve. Nice to talk to you today.

Steven Levine

Yeah, great to have you back. We had this great discussion earlier this year. I’m sure you remember that.

Joe Burke

I do.

Steven Levine

We had this podcast called ‘Inflation, Rates, and Recession – What’s the Worst That Could Happen?’ We explored, among other topics, yield curve inversions, and their being an indicator of a coming recession – something like a year, or 16 months, or 18 months out from the time of the inversion. That’s my understanding of them, historically. We talked a bit about the 2-year / 10-year relationship [and] the 3-month / 10-year … and today both parts of this yield curve are well into negative territory. The 2s/10s part … at least since July … now close to around. 60 basis points out. [The] 3-month / 10-year … since the latter part of October, now at about 50 basis points. I mean, there seems to be a lot of variables, I suppose, influencing each other, and I thought we could spend this time making some sense out of what’s happening in the rates environment, its relationship with, say, other factors like GDP, monetary policy, inflation…. To my mind, it’s a lot to unravel, but I thought we could start off with your insights about these yield curve inversions. Why are they happening? And what are your thoughts about their usefulness today as an indicator for recession?

Joe Burke

I think I think they’re happening as a result of the Fed’s tightening, and the expectations that the Fed will tighten further. And when you consider what the impact of tightening is – it basically will be either just a slowdown in growth, or potentially a recession, or worse. So, what the market’s doing is saying that ok, the short end of the yield curve is going to follow Fed funds, and the Fed’s hikes. But we don’t believe that’s going to that inflation will be a long-term problem, and that’s why as you go out the curve – out towards like the 5-year sector – you’re seeing that rates are coming down. The expectation is that the Fed will not need to maintain an aggressive monetary tightening for a long period of time. As you pointed out, though, we’ve been in negative territory between 2s and 10s for quite some time, and what’s interesting to me is how inverted we are. If you go back to 2000, we had an inverted 2-year / 10-year curve around 50 basis points, and that lasted most of the 2000 to 2001 year. And then we went into that recession in late 2000, but that was … in part you had the dot-com crash … you had other … maybe Y2K had some had some influences. But I think that this is potentially going to be a very protracted inversion, and I think you could see this last well into the two to three-year time period.

Steven Levine

Can you characterize a recession based on the length of time that that part of the yield curve remains in negative territory? Or how deeply it goes negative? I mean, for example, the 3-month / 10-year went from like 4 [basis points] to 60 basis points in like less than a month. And that was quite a move.

Joe Burke

That’s sort of the point … we’ve been inverted for a while now. I generally track 2s and 10s, but it’s accelerating … the inversion is. If you look at the 2000 inversion, it was relatively brief and it got down to 50 basis points, but then it bounced off of the 50-basis points level and sort of started going closer to zero. We seem to be accelerating here. Every day it seems like we’re further and further inverted. To me, that tells me that the expectation is the Fed is going to tighten in December and again in March. But after that, it looks like it’s over. But you know, by virtue of this inversion, and the acceleration of the inversion, I think that perhaps the market is suggesting that’s not the case, that we’re going to tighten more.

Steven Levine

Does it also foretell anything about a potential recession? Does it say that the recession would be deeper than we would otherwise have? Or does it say the more negative these basis points become, does that mean that the recession itself would be more severe?

Joe Burke

I do think so, because the more aggressively they tighten, the more of a shock that is to the economy, and the risks increase that we’re gonna have a recession. You’re starting to see payroll numbers roll over a little bit, particularly in the tech industries with all the layoffs. If that becomes more broad-based, it could be a real problem. The Fed is definitely walking a tightrope here. And, I think the idea with the deeper the inversion the more likely that we have a protracted recession.

Steven Levine

And I’ve heard some analysts talk about 1981 as a reference point in terms of, say, GDP, inflation rates…. I don’t know if we’re in unprecedented territory now, in a way. But if we make some kind of comparisons, for example in ‘81, I understand 2s / 10s went negative to around 100 basis points. Some analysts believe we could get there with where we’re going now, as well. [The] backdrop, then I believe it was in that year Paul Volcker, who was the chair of the Fed at that time, was facing GDP growth at about 2.5%, unemployment at about 8.5%, inflation was, I believe, 10.3%. So, at the peak, I guess that’s the terminal rate, Fed funds went to 20% and then gradually came down from there. That recession lasted until November of ‘82, so we’re looking at about a year’s worth of recession, it looks like. At the end of December of ‘82, inflation was down to 3.8%. So, today, GDP is about the same as it was then – about 2.6%, unemployment is much better than in ‘81 at 3.7%. I don’t know if you factor in participation rate and other factors, but just on unemployment rate basis, it’s far better than ’81. And inflation somewhat lower it at like 7.7%. But can we say that the Fed’s tightening strategy now is working to ease inflation? I mean we’re looking at, as you say, more expectations of tightening by the Fed, so they’re not done yet. I guess it’s maybe it’s too soon to tell?

Joe Burke

I think it is too soon to tell. We’re also dealing with sort of a hangover from COVID, right? We have supply chain issues to this day. I was speaking with a colleague whose family has a business that has been seeing supply chain challenges to this day. So, it wasn’t just toilet paper like during COVID. It’s across the board, and it’s an ongoing issue. So, there’s price increases due to supply chain issues.  So, I think it’s too soon to tell, but we have other factors. Also, consider the liquidity that the Fed has pumped into the economy over the last 10 years, right? It’s a massive amount of liquidity … so that differentiation differentiates us from 1980 or ‘82.

Steven Levine

Yeah, in a big way.

Joe Burke

Yeah. So, the Fed is draining liquidity … raising rates. You have basically full employment at this point. You have a tremendous demand for workers, and yet you’re seeing some dips in employment in certain industries – certainly the tech industry seems to be a little bit overbought at this point. And you’re seeing those layoffs.

Steven Levine

There’s all sorts of things going on. I understand supply chains, but also exacerbating this in a huge way, I think, not only zero-COVID policy or constraints in China, for example, but also in a reverse way in terms of chips and semiconductors, and the U.S. imposing certain bans on facilitating or helping China really advance their technology. But what I am interested in is rates are going higher, yes. And, so, this means a great opportunity for corporate bond buyers, I suppose, as well as municipal bond buyers – really any fixed-income product that’s tied to rates. I’m sure that’s getting less expensive in terms of purchasing these, but I guess that comes at a huge risk as well. So, what do you say to the tenors of these? I mean, do you hold them for 5 to 10 years and hope that these rates reverse in due course or…?

Joe Burke

I think with corporate bonds, in particular, you’re looking at the credit spread. So, corporate bonds obviously are impacted by the overall interest rate environment, but they’re also impacted by credit spreads. So, if the stock market starts to roll over and we get into a bear market, corporate credit spreads are gonna widen along with that. So, you can really get hurt as a corporate bond buyer. That said, what we see or hear from some people is that they’re sort of relative value type of buyers of corporate bonds. They’re looking at a historical time and say, ‘Okay, this should trade at plus 150. It’s trading at 175, so it’s cheap on a relative value basis, so I’m going to get long here and look to exit that position when it gets to say 140 … if it goes my way. So, that’s what we see and hear about a fair amount is this sort of looking at. The clients are buying bonds for moves, not necessarily just for income. I mean, yes, a traditional bond buyer will buy a bond to earn some level of interest and ‘clip coupons,’ if you will. But there are as many out there who were looking to play the market for a move in the credit spread.

Steven Levine

That makes a lot of sense. It also seems to be, like you said, a fairly dangerous play to get into this space the more that it looks like this recession … as perhaps as you characterized it … could be fairly prolonged or severe, given the inversions that we’re facing.  So, municipal bonds as well. I mean, municipal bonds must be facing some real hard times, I would think, as well. They’ve got all sorts of issues that they contend with in terms of, I suppose, the political environment, et cetera. But they also operate with respect to rates going higher. So, what do you think about this market?

Joe Burke

I think with munis, there’s been an awful lot of pre-refunding of muni issues over the last few years. So, I think that a lot of the municipalities that could pre-refund have done so, and they’ve been able to lower their borrowing costs ahead of the Fed tightenings. And I think that many are in pretty good shape. I mean, there are some that are that are perennially struggling, but I think most of have pretty clean balance sheets. So, it will have an effect on new projects … they want to raise money to go build something … highway or whatever. That’s going to raise the cost of capital for sure with higher rates, but overall, I think that the market, and the issuers in the marketplace, have done a good job of taking advantage of the lower interest rates when they could.

Steven Levine

We did see certain defaults, I remember, not too long ago, and there were some fears of some contagion in terms of default. It wasn’t huge, but it did happen, I believe in Alabama at the time. I remember that. I think Detroit also defaulted at one point. Yeah, there were some big, big defaults. New York also faced a default, I remember, in ‘75 or something like that. So, is there any talk or fear that we might be seeing some kind of wave of municipalities defaulting?

Joe Burke

I don’t think so. I mean, New York … certainly during COVID … there was a lot of concern about New York because they have so much debt, like the Transit Authority, New York State Dormitory Authority…. These are large issuers of municipal bonds, and the concern was: ‘Well, if no one’s going to college, and they’re not paying the room and board, where’s the revenue going to come from to make the interest payments on these revenue bonds, right?

Steven Levine

Yeah, yeah.

Joe Burke

Same thing with the Transit Authority – no one’s crossing the George Washington Bridge, because they’re home. And there was concern. I mean, there was talk about it. We talked about it internally. Is there something to be worried about? And it turned out to be just fine there. And the rating agencies have continually assessed these issuers, and I am not aware of anything that’s problematic.

Steven Levine

It’s a tough city, right? It’s pretty resilient. It seems like it can pretty much withstand an entire economic lockdown, and their munis will still be pretty resilient.

Joe Burke

Right.

Steven Levine

That’s great.

Joe Burke

Right.

Steven Levine

And a with the corporates – are there certain sectors that you think would fare less widening than others? Probably to certain defensive sectors I would think. But it’s likely that there will be certain areas of industry that will fare better, or at least not fare as badly, during any potential severe recession – in your view?

Joe Burke

I think industrials are always the one you worry about, because if the economy slows dramatically, the number of John Deere tractors that are purchased will drop as well. So, those types of things … and energy is a commodity, really. So, potentially they will perform well, as long as energy prices stay high. But I would think the bigger issue is going to be – it’s going to be industrials, and perhaps tech. As we talked about a few minutes ago, tech has some struggles lately. We’ve seen certain companies laying off … does that continue? Is it just they needed to do a little bit of pruning or is there a real problem there? And I don’t think we know yet.

Steven Levine

There’s some talk that I’ve heard from some analysts about digitization. I’m not sure if that factors in here exactly, but it seems that perhaps the U.S. has reached a certain peak in terms of its digitization capacity or capabilities? Maybe it’s become too much of a mature market, where other regions are kind of either catching up or have their own industry that can handle what they need in terms of technology – like Asia, for example, or Europe. So, I don’t know. It’s a very fascinating thing to look into and see what’s happening within technology, but it’s poised for certain risk that may be unexpected.

Joe Burke

Right. Right. Definitely something to watch.

Steven Levine

So, we’re talking about certain products … corporate bonds, municipal bonds, Treasuries, but the Treasury also has done some moves with certain products that it hadn’t done before, or at least very recently. For example, it transitioned its 4-month bill to benchmark status. It did that pretty recently. It also reintroduced its 20-year bond. I think that’s the first time it did that since ’86. It said it’s part of an additional tool to expand its borrowing capacity. But how do you see these products in terms of their potential benefits and risks? Could we have done without them? Or why is the Fed making these moves with these particular ones?

Joe Burke

We’ll talk about the 20-year first, but there’s a big gap between 10s and 30s. Having a 20-year benchmark bond gives a little bit more structure to the curve … the longer end of the curve. So, I think it adds some value from the standpoint that you have a more inclusive curve, if you will. Because what happens is you get these 30-year Bonds that are issued, and as they start to move down the curve there’s a bit of a disconnect between where they should be trading – relative to the 30-year and relative to the 10-year. So, to have a benchmark in between those two, I think it sort of firms up the curve.

Steven Levine

And I know you’ve been experiencing quite a bit of activity pretty recently on your side of the desk with rates and fixed-income. We talked about that a bit earlier. Even today, it sounds like you have your hands full these days with where rates are going. Is the 20-year anything that you experience as being something of dealing with a lot of activity there or…?

Joe Burke

No. I’d say… I don’t look at it daily, but it seems like our client base tends to be more focused on 10-years and in rather than the longer end of the curve. Historically, that’s what I’ve observed … is that where our clients tend to be involved in the 10-year and in sector of the curve, a lot of bills, a lot of short coupons, a lot of off-the-runs. Sometimes these off-the-runs can be a basis point or two cheaper to the on-the-run. And I’ve seen clients take advantage of that increased yield.

Steven Levine

How would you describe the environment today with your clients? I understand they’re going from 10-years in, but in general, what’s the attitude out there in the Street … as rates are climbing … as the inversion is getting deeper, it seems, and accelerating, as you mentioned? What is the sentiment out there? How are how are clients reacting? How are people reacting in the fixed-income markets?

Joe Burke

I think, to a large degree, we have interest rates now that are above zero, so I think there’s a great deal of celebrating about that for people who have a have a portfolio that is at least part fixed-income. For a long time … for many years … you’ve had rates near zero. You know – 2007, 2008 after the credit crisis, the Fed lowered rates. Then we went up a little bit, and then COVID came and went back to zero. So, this is like the first time in a very long time that we have solid 4-handled yields on Treasurys. It has to be back to, I would guess, 2005 or so would be the last time we had rates this high in the sort of the belly of the curve. But yeah, I think there’s a general degree of happiness that there’s stuff to buy. I mean, there’s obviously caution that the Fed could continue to tighten. That’ll erode the value of your fixed-income instruments. But to the extent that you have a fixed-income portfolio, when you go out and buy … put money to work now … you’re earning something on your cash.

Steven Levine

Yes, we have had quite a journey of this target range of the Feds fund rate. And I think that was introduced actually during the credit crisis. I think it was Bernanke came out with like a new target range between zero and 1/4 percent… So, it was effectively at zero. And they’ve had the hardest time trying to lift off of that for years. I don’t think was for lack of trying. I think they did try to lift off from that place, but you had taper tantrum … I think that was something like 2013 or ‘14.

Joe Burke

Sounds right.

Steven Levine

In that area. And then you had the sovereign debt crisis in Europe really throw everyone for a loop from 2011 through the next few years – I think through until about 2014, ’15. And as soon as it seemed like we were getting higher in rates, it was a flood back into the Treasury market to capitalize on that. And then just tamped them back down again, so it was almost impossible to get to get off of them. So yeah, I’m sure that people are very happy about that. I suppose there’s also a lot of fears about unrealized losses because of that, as well. I can just imagine that…. How much higher do you think they could go? I mean, where do you think, say, for example, the 10-year could go? The end of the year is about a month from this recording, so let’s say that we’re close to the end of the year now. Where do you think we’re at?

Joe Burke

I think 375 [in basis points, or 3.75%] … maybe 380 [bps, 3.80%] … on the 10-year. It kind of depends. I think we have to really watch nonfarm payroll, and all the other data that comes out that matters … PPI, CPI, durables, retail sales…. Any sort of sign that the economy is kind of weakening is going to be problematic, and in that case, I would expect the 10-year to go the other way. I expect to see the 10-year getting closer to 3 1/2 [350 bps or 3.5%] rather than 3 3/4 [375bps, or 3.75%].

Steven Levine

That’s great. That’s great. And I suppose we can ask you what you think now … because we had this podcast before about what’s the worst that could happen. I think that in our last discussion you had mentioned that, basically, I think that inflation could be like a runaway freight train, like maybe there was no stopping it. Maybe the Fed was behind the curve, and they were a bit too late in raising rates, as they’re doing now to try and combat it. But now that we’ve seen the Fed raise rates a few times this year, and now that rates have lifted off of that zero to 1/4 percent … effectively zero percent bound … what do you think the worst is going to happen at this point?

Joe Burke

I think the worst thing that could happen is we don’t show two things: when we don’t see any relief from inflation. So, we’ve we had a temporary pause recently, and we hope that that continues, but what if it doesn’t? If the inflation numbers next month, and in January, look bad? What happens when China comes back to life from the COVID lockdown? Does that accelerate inflation in the U.S. or…? So, you have that. And then I think you have to again look at labor. If the tightening is causing significant layoffs and the economy weakens, then you have our 1970s problem with stagflation, right? You have, if higher rates, the Fed trying to raise rates to tamper inflation not really succeeding, but at the same time  causing damage to the economy, and losing their political will to continue to tighten, because of the suffering a weak economy would cost. Hopefully, we don’t get there, but I just throw it out there as a possibility.

Steven Levine

That’s a very dire scenario. It’s very dark, and I think looking at inflation in the UK today, I understand that was another 40-plus year high for them. I think was something at 11%. I think, if I’m not mistaken, but if that’s any indication of where inflation could go in terms of where we’re at…. It’s been gradually sort of sinking lower, but that’s no real indication of a trend in that direction. It’s been kind of plateaued at about 8%, it seems, for the past few months. So, I cross my fingers that we will see something work out here, and not get into such a horrible area. And so, along the way, what do you think would be a great strategy for investors, say in the fixed-income space, or any other space, to watch out for … headwinds or catalysts that they should remain cautious of? I know you listed a bunch of economic reports … durables and CPI, et cetera, but perhaps there are other things that they should be mindful about?

Joe Burke

I think, in general, portfolio laddering is generally a pretty safe bet. If you’re going to put some amount of money to work, ladder … construct a portfolio that whatever asset class you’re talking about, whether it’s munis or Treasuries or CD’s or corporate bonds, a laddered portfolio lets you participate in your maturities out to say six years, or out to 10 years … whatever period you feel comfortable with and have a maturity every two years or every year. So, you have risk that rates go up or down, but this way you participate if rates go up, and you help to mitigate your risk by having money returned to you on a regular basis that you can reinvest at the better rates. It’s a very simple strategy, but I think it can be an effective one, and I think there’s a lot of people who do that. I think it’s sensible.

Steven Levine

It makes a lot of sense. Is there anything else that you’d like to mention?

Joe Burke

Yeah, our Treasury volumes have increased dramatically, now, obviously part of that is the higher interest rates, and more clients being interested in Treasurys. But we’ve also added a new venue, a Tradeweb institutional, which is an RFQ based platform, where we have seen our volumes explode. As a result of adding this venue, the liquidity available on Tradeweb is fabulous, and our clients are able to take advantage of that.

Steven Levine

That’s awesome.

Joe Burke

They’re getting institutional pricing on one lots, if you will. So, it’s all algo priced … they get responses back very quickly. It’s working very well for us, and I’m very happy with the results.

Steven Levine

That’s awesome, that’s awesome. It’s great to hear. Joe, thank you so much for doing this. I mean, this is really, really great. Always great to have you here, and I hope you’ll be back with us, again.

Joe Burke

Sounds great, Steve, thank you.

Steven Levine

You can read more commentary and market analysis at IBKR Traders’ Insight at tradersinsight.news. You can keep abreast about topics there, such as those we’ve discussed today, as well as a wide range of other news critical to your investment needs. And for a full list of financial educational offerings, visit the IBKR Campus at ibkr.com. As always, all of our educational material is provided to the public at no cost.

Thanks again Joe, I really appreciate it. It’s great.

Joe Burke

Alright, thanks, Steve.

Steven Levine

Thank you. And until next time I’m Steven Levine with Interactive Brokers.

Learn More:

U.S. Department of the Treasury – Interest Rate Statistics

Federal Reserve History

CNBC: What Happened in Every U.S. Recession Since the Great Depression

IBKR Traders’ Academy

Introduction to Treasuries

Introduction to U.S. Corporate Bonds

Introduction to Municipal Bonds

Fixed-Income Trading for TWSFinance Courses in Economics

Disclosure: Interactive Brokers

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