The previous three articles in this series have brought us to the most powerful yield curve market signal of all — one that is highly reliable but almost unknown in its significance. Very few Wall Street analysts even know where to look. This signal is called inversion.
Inversion refers to a yield curve that slopes down instead of up. In other words, future rates aren’t merely flat relative to current rates, they’re lower. There’s no reason for this downward slope to happen given the risk premium concept discussed last week — except to signal not just a probability, but an almost certainty about a recession (or worse).
Inversion appears in a slight fashion in the Treasury yield curve shown in part three of this series. If you look at the blue line (the current curve), you’ll see it slopes slightly downward in the 7–10-year sector. The seven-year note yield to maturity is 2.825%, while the 10-year note yield to maturity is 2.796%. The difference is only 0.029%, but down is down. There’s no reason to accept a lower yield on 10-year notes than seven-year notes, unless you’re expecting a recession, a liquidity crisis, or worse.
The inversion appears in an even more dramatic fashion in a yield curve almost no one considers. This is the Eurodollar futures yield curve.
The Eurodollar rate is the interest rate that large banks charge each other for overnight dollar loans in international markets (it has nothing to do with the currency ‘euros’). Eurodollars are how banks finance leveraged positions and loans to customers.
Eurodollar futures are long-term bets on short-term interest rates. As such, they may be the most powerful predictive analytic tool for forecasting the economy and markets that exists. Eurodollar rates can provide an early warning of a global liquidity crisis. Overnight bank liquidity is the real backbone of the global financial system — much more important than central bank policy rates or pronouncements from the Fed.
Eurodollar futures are settled monthly for the first year forward and quarterly beyond that. Contracts trade 10 years into the future (although trading is quite thin beyond five years forward).
For those interested in some of the technical aspects, Eurodollar futures trade on the CME in packs and bundles identified by a colour-coded system. When trading packs, the first four quarterly settlements are called Whites. The next four (1–2 years forward) are called Reds. The following four (2–3 years forward) are called Greens. The four after that are Blues, and the next four are Golds. This colour-coding continues to 10 years, but as noted, there’s not much trading beyond the Golds.
What is the Eurodollar futures yield curve telling us?
The detailed pricing information is evident on the chart below. (This is not strictly a yield curve presentation, but it has the information contained in a yield curve in chart form. This is a more useful format for our purposes.)
One more technical note before we jump into the data. Because these are overnight rates, they’re calculated as discounts to par of 100. Therefore, the lower the price, the greater the discount and the higher the yield since the contacts all settle at 100. In a normally sloping yield curve, discounts to par prices would get lower over time, which means a higher yield to the investor. That’s a normal risk premium.
Beginning in June 2022, we see a price of 98.187. Continuing quarterly through June 2023, the price gets lower every quarter, which means yields are going up. That’s normal.
Then comes the shock. The September 2023 price is higher than June 2023.
The price jumps from 96.685 in June to 96.8 in September. The higher discount means overnight rates are dropping in the Reds (1–2 years forward). This drop in forward rates persists through September 2025 before finally hitting a higher price (lower rate) at 97.13. Beginning in December 2025, the prices go down again, meaning rates start going up — albeit slowly.
[Editor’s note: Prices beyond September 2024 aren’t shown on the chart below. For complete information and continual updates, please check this site.]
A recession is coming
This Eurodollar futures curve inversion is not just an anomalous bit of data. It has signalled every recession in recent decades. It’s the single most reliable early warning signal available.
Of course, more data from more sources is always better. Cumulative data can be used to confirm (or refute) existing hypotheses and get a sense of timing and severity, even if we’re sure a recession is coming. Still, if we had to rely on one, and only one, data point, this inversion in Eurodollar futures would be it.
So, there it is. We have a slight inversion in long-term rates as shown in the 7–10-year sector of the Treasury yield curve. We have a pronounced inversion in overnight rates in the September 2023–2025 section of the Eurodollar futures curve (Reds and Greens). The correlation of both inversions to a coming recession is high.
The particular sectors of both curves showing the inversions doesn’t necessarily mean the recession is that far away. The Treasury curve inversion just means investors are taking stock market chips off the table and investing in intermediate-term Treasury notes instead.
The Eurodollar futures curve inversion can roll forward from late 2023 to early 2023 quickly (in fact, it already has rolled forward from 2024 when the inversion first arose about six months ago).
The system is flashing red. That’s the bad news. The good news is there’s still time to adjust your portfolios ahead of a recession or market crash.
But before we get to that, one last warning…
The yield curve lives in unusual times
While the yield curve inversions described above signal recession, it’s also true that the forecast is subject to an unusually high degree of uncertainty and volatility. This is because we haven’t seen quite this combination of inflation and slow growth since the 1970s, and we’re now experiencing the worst land war in Europe since 1945.
We’re also in the midst of a supply shock that rivals the 1970s and a broader trade disruption comparable to the 1930s.
All of these factors make forecasting (even with reliable indicators) more difficult than usual.
Still, it’s an important input to our Bayes’ theorem-style analysis and has important implications for your portfolio:
Source: CME Group
If you’re confused, here’s what it all means. What the Eurodollar futures yield curve is telling us is that beginning in September 2023 and persisting for two years, the institutional investors and market professionals who actively trade this market expect overnight interest rates to decline.
This does not signal inflation.
This does not signal high growth.
The signal clearly indicates a recession along with a possible market crash or worse.
All the best,
Strategist, The Daily Reckoning Australia
This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events. Learn more here.