There’s a lot of fear at the moment regarding rate rises and their ongoing effect on the economy.
No one expected the latest 0.25% increase in the cash rate — it caught markets by surprise.
There’s now clear indication that the RBA may have tightened too much, and as a consequence, the Australian 2–10-year yield curve has *just* inverted.
Source: AMP Capital
An inverted yield curve might sound like some complex financial jargon, but it’s pretty straightforward once you break it down.
The yield curve is just a fancy way of talking about the interest rates that the government pays on its bonds.
It shows how those interest rates change over time for different loan durations. Usually, the longer the duration of the loan, the higher the interest rate.
When we say the yield curve is inverted, it means that this normal pattern gets flipped on its head. In other words, the interest rates on short-term loans, like three-month or two-year bonds, become higher than the rates on long-term loans, like 10-year bonds.
So why is it a bad omen for the economy?
Well, the inverted yield curve is often seen as a sign that people are losing confidence in the future. When investors start to worry about the economy’s prospects, they tend to put their money in safer, long-term investments like government bonds.
This increased demand for long-term bonds drives down their interest rates, making them lower than the short-term rates.
When short-term interest rates become higher than long-term rates, it has negative effects on the economy.
Banks and financial institutions typically borrow money in the short term at lower rates and then lend it out in the long term at higher rates. But when the yield curve inverts, their profit margins shrink as the cost of borrowing becomes higher than they can earn from lending.
As a result, banks may become more cautious about lending money, which can tighten the overall availability of credit. Businesses find it tougher to get loans for investments, consumers might struggle to get mortgages or car loans, and of course, this impacts the economy.
In a nutshell, an inverted yield curve has historically been a leading recessionary indicator.
Think of it this way — GDP, earnings, and the unemployment rate all tell a story of the past. The yield curve shows a picture of future expectations.
The last time it dipped into an inverted state in Australia was back in 2006 — and it stayed that way all to the 2008 GFC.
It was a pretty good indicator of what would come. Although Australia didn’t dip into a technical recession, we still felt significant shock waves from the GFC.
The Australian yield curve is not as accurate in forewarning recessions as the US yield curve.
In the US, the 2–10-year yield curve has been inverted since July 2022:
Source: AMP Capital
When viewed in the context of the 18-year cycle, an inverted US yield curve can be a very accurate leading indicator of a forthcoming recession.
This is because the US leads us into and out of the recessionary points of the 18-year cycle.
Most look at the 2–10-year bond spread as I’ve done above.
However, the relationship between the three-month to 10-year spread arguably gives a more accurate signal.
Campbell Harvey, Professor of Finance at Duke University, was the first to study this in depth in his dissertation in 1986.
He evidenced that the three-month to 10-year spread inverting for at least one full quarter has predicted every recession accurately since 1960.
His research didn’t get much attention until Harvey predicted the economic recessions in the early 1990s and 2000s ahead of time. Now inverting yield curves are a widely talked about indicator.
(Although the core reason for the recessions — rising land values and the effect of monopoly speculation on the productive sectors of the economy is, of course, rarely mentioned.)
A recession tends to occur around 12–18 months after the three-month to 10-year yield curve inversion takes place.
However, it’s crucial to understand that this average is not a precise or fixed timeline. The timing can differ between different economic cycles and depends on various factors.
The US three-month to 10-year yield curve has been inverted since October last year.
Does it, therefore, mean we’re facing an early recession…prior to the forecast in 2028?
Or, for that matter, an early peak to the 18.6-year cycle in the US?
The current inversion has been quite drawn out, and it does indeed point to a recession.
If so, it may come at the end of the year. But if so, it will probably be a shallow one. In other words — one that doesn’t involve a housing crash. Similar to what we saw in the US in 1970, prior to the downturn in 1973–74.
Remember, recessions mid-cycle don’t impact the economy as significantly as they do at the end of the cycle because the property market is not severely impacted.
As it currently stands, I have the anticipated peak for the US market timed (via the nodal cycle) for 2025. I’ll see how things play out closer to the date.
The peak in the US market tends to correlate with the major Lunar standstill at the end of the cycle, as I pointed out here.
It did this in 2006 and before that in 1988.
The Australian property market, however, peaked in 2008 and 1989. So, 1–2 years post the US peak. For this cycle, it is predicted to be 2026–27.
How can we be sure that we’re not at the peak in the US yet?
Well, there are a few other leading indicators to pay attention to.
One is the equity prices for individual homebuilder stocks in the US.
I was having a conversation about this with our favourite data analyst, Philip Soos, the other day.
If we look at the equity prices of the 10 largest US home builders that are publicly listed, for those with a long-term history, they all peaked in mid-2005 and then collapsed. Even by mid-2006, they are either one-third to one-half down from the peak.
Right now, all of them, without exception, are booming, despite higher interest rates and fears of recession.
Giving indication that we’re not there yet!
Additionally, there’s better news re: US inflation.
US producer prices fell -0.3 per cent in May.
The year-on-year figure fell faster than expected, down from 1.9%last month to a 1.1% increase.
The USA Federal Reserve put a pause on increases in their last meeting.
Does that mean we’re at the end of the rate hiking cycle? No — the second half of the cycle generally features rising rates (alongside rising property prices, I should add). But it does perhaps signal that the pace of increase will slow.
Mortgage markets in the US have picked up also.
According to the latest survey by the Mortgage Bankers Association, mortgage applications shot up by a solid 7.2% compared to the previous week.
The increase in applications came along with a small dip in 30-year mortgage rates.
Additionally — as we’ve seen in Australia — there’s a low inventory of US homes up for sale. Low supply, in other words.
Therefore, home prices in the US are on the rise.
According to the latest report from the S&P CoreLogic Case-Shiller US National Home Price Index released on Tuesday, March marked the second consecutive month of price increases.
In February, prices went up and broke a seven-month streak of declines.
Once we adjusted for the usual seasonal changes, the national index showed a 0.4% increase in March compared to February.
The 10-City and 20-City composites also saw their prices go up.
Without making any seasonal adjustments, the National Index had a 1.3% month-over-month increase.
So, despite the turmoil and risk of the US slipping into recession, it’s not signalling that we’re at the end of the cycle — yet.
There’s still further to go.
Editor, Land Cycle Investor