Here Is Why You Should Ignore The Inverted Yield Curve

Regardless of how bullish the market internals have become in recent weeks, we are long overdue for a pause or a pullback in the major market indexes, but we need a trigger. It appears that last week’s strong jobs report for January is it, as interest rates have risen, Fed officials are showering investors with hawkish rhetoric, and options traders are placing bets that short-term rates could approach 6%.

To top it all off, retail investors are turning optimistic, following the 17% surge in the S&P 500, with the latest survey from the American Association of Individual Investors turning bullish for the first time since last April. This is a recipe for the pullback to 3,900 that I wrote about on Tuesday, and it will surely reinvigorate the bearish narrative, as the yield curve inverts to levels not seen since the early 1980s.

I have been calling for a soft landing since the depths of the bear market last October. At that time, it was not a popular forecast, but short-term rates, as measured by three-month yields, were still modestly higher than long-term rates, as measured by 10-year yields. My outlook for a soft landing last fall was based on the strength of the labor market and the excess savings built up by consumers.

I am still holding that position, but the one thing that has kept me uneasy since then is the growing inversion of the yield curve, as three-month yields are now more than 100 basis points higher than 10-year yields. There have been eight inversions like this since 1968, and everyone was followed by a recession. Those are not good odds for my soft landing scenario.

Regardless, I have stuck to my guns on the basis that the building blocks to this post-pandemic expansion are unprecedented. Yes, this time is different. I recently learned that I am in good company, as economist Campbell Harvey agrees with me. He is not just another economist, but the one who is credited with identifying this inversion indicator decades ago. Now I feel like I’m playing two-on-two basketball with LeBron James as my teammate.

In a recent interview, Harvey also noted the strength of the labor market as one reason this time may be different. In addition, he suggested that this indicator has become so widely accepted that its trigger may now be impacting corporate and consumer behavior to the extent that both take actions to fend off a contraction in economic activity. The most important reason was a fascinating revelation for me-he reminded us that his model is linked to inflation-adjusted yields.

Therefore, if we adjust today’s 3-month yield of 4.7% with the current CPI of 6.4%, it produces a real yield that is a negative 1.7%. If we adjust the 10-year yield of 3.65% with 10-year inflation expectations of 2.25%, we have a positive yield of 1.4%. This is a spread of more than 300 basis points in a curve that is no longer inverted. This is why Harvey stated last month in reference to his yield-curve indicator that “I have reasons to believe, however, that it is flashing a false signal.” I feel more comfortable ignoring the inverted yield curve for now.