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Wednesday 02 August 2023 by Garreth Innes a bowl of eggs Opinion

Macro Musings – has the yield curve led us astray?

As the divergence between equities and bond markets further widens, it begs the question if portfolios should be positioned for a risk-on or risk-off environment? Here our Deputy Head of Research, Garreth Innes, discusses the implications of key indicators and why diversified portfolios are best.   


There is an inside joke within financial markets that between equity and bond investors, the latter are the smart ones. This might have something to do with the rather complex mathematics that goes into bond pricing or the historical tendency of the yield curve to front-run risk-off episodes. Whilst we certainly wouldn’t paint our equity brethren as such, it is noteworthy that we have recently seen a break between equity and bond market pricing, and another battle between the forces of good and evil has commenced:

Figure 1: US 10yr yields vs. S&P 500 forward Price/Earnings ratio

US 10yr yields vs. S&P 500 forward Price/Earnings ratio

Source: Bloomberg

In this note, we explore some reasons why the US yield curve might be leading us astray as well as delving into some real-time indicators for a pulse check of the US economy.

Inverted yield curve – what does it tell us?

The last month has been characterised by an exciting surge of so-called ‘risk-on’ moves across markets. From what we can ascertain, not all of this can be attributed to the Oppenbarbie / Barbenheimer dynamic. What commenced as a rather narrow ‘Artificial Intelligence' thematic has broadened out to cyclical stocks, credit spreads, and commodity prices. Most of the time, these sorts of moves would be correlated with bond market weakness (from a price perspective, causing higher yields).

How can this be, when the inverted US yield curve (see Figure 2 below) and other forward-looking indicators have been ‘telling’ us that we are headed towards an economic recession? Remember, the yield curve has not been this inverted since the Global Financial Crisis, the initial Covid-19 market reaction, and the Dot-Com bust.

Figure 2: Historical Yield Curve inversions (the spread between 3-month T-Bills and 10-year bond yields)

Historical Yield Curve inversions (the spread between 3 month T-Bills and 10-year bond yields)

Source: Bloomberg

The market tends to rely on forward-looking indicators such as the LEI (Leading Economic Index) as a guide for likely economic outcomes and asset allocation. You’ll often find the LEI mapped against subsequent moves in US 10-year bonds, indicating some degree of forecasting power of the LEI. For reference, a level below zero for the LEI generally indicates some level of upcoming weakness.

Figure 3: LEI vs. US 10-year bond yields

 LEI vs. US 10 year bond yields

Source: Bloomberg

One problem with this approach is that the shape of the yield curve is actually a component of the LEI itself, which implies a two-way relationship between the input and the output (or what economists call ‘endogeneity’). This can create challenges in estimating causal relationships and making accurate predictions.

A closer look at the LEI reveals that the Interest Rate Spread (that is, the difference in the yield between long bonds and short bonds) is one of two main contributing factors to the negative prints on the index thus far in 2023, as per the last line in Figure 4:

Figure 4: Contributions to LEI, Dec 2022-June 202

Contributions to LEI, Dec 2022-June 2023

Source: Bloomberg

The other main negative contributor is the ISM New Orders component. There have been some interesting dynamics at play in this indicator coming out of Covid-19. The extended lockdown period resulted in people shifting consumption from services (eating out and travelling) to buying goods (like Pelotons) along with the occasional service like ordering Uber Eats. This coincided with supply chain challenges which restricted the supply of goods against growing demand, the latter partly due to government handouts that boosted consumption and the subcomponents of the ISM New Orders (manufacturing and services). As ever, things ultimately changed, leaving sellers with bloated inventories (that are still being reduced right now). Another result of high inventories (and dwindling supply chain issues) is lower inventory stocking, which is now dampening the ISM New Orders reading (in addition to the potential slowing of the economy):

Figure 5: New Orders falling after Covid-19 pickup in Inventories

New Orders falling after Covid-19 pickup in Inventories

Source: Bloomberg

Back to the yield curve. The inverted nature of the yield curve could also be due to the somewhat worrying maturity profile of the US Treasury. Figure 6 shows the distribution of the roughly USD17trn outstanding debt across the years, and the obvious takeaway is that there is a lot more at the short end of the yield curve than the long end:

Figure 6: US Treasury Debt Distribution

US Treasury Debt Distribution

Source: Bloomberg

This was exacerbated recently as the Treasury Department issued cUSD700bn of T-bills (short-dated bonds) post the debt ceiling episode, which was lifted in May 2023. If the heightened supply of US treasuries at the short end of the yield curve is maintained, this will keep these bonds cheap relative to long-dated bonds (all else equal). If the Treasury Department extends the average maturity of its debt, it would be increasing the supply of ‘dollar duration’ and the yield curve would likely steepen (a more normal shape), lowering the value of longer bonds and putting pressure on technology stock valuations – remember, the market segment that kick-started the recent revaluation in global equities.

One reason why the Treasury Department might want to maintain its current refinancing strategy is that it too doesn’t believe in significantly higher long-term interest rates. Rather than locking in >4% cost of debt for 10 years and longer, it would happily pay 5% for two years and hopefully refinance (and potentially extend the tenor) at a much lower rate in two years’ time. I wouldn’t put too much faith in the US Treasury Department’s views in this regard, even with a former Central Bank Governor (Janet Yellen) at the helm.

A final point on this debt distribution – as a credit analyst, I would be pretty worried if a company had a very front-loaded maturity profile with increasing interest costs on its unhedged debt. I would express my desire for the company to lengthen its average debt maturity, but would also chastise the Treasurer for not doing so while rates were at all-time lows!

So the yield curve might not be a perfect indicator…

We have just attempted to ‘explain away’ the two factors dominating the negative contributions to the LEI, as well as rationalise the shape of the US yield curve to some degree. If, after all of this, we are left with mostly flat/positive readings in the LEI and a more sanguine view of the inverted yield curve, should we really be so worried about an impending recession? Are there other coincident economic data points that can justify a more constructive view of the US economy (outside of the labour market strength, which is broadly understood)?

A couple of interesting indicators in recent weeks that could be helping risk assets bounce:

A broadly underweight institutional equity allocation that is cutting losses as the market continues to rally. Interestingly, the dislocation between retail equity investors and institutional equity investors has seldom been this large. Are retail equity investors the real smart ones here?

Figure 7: AAI Total Stock Allocation vs Net % of BofA Manager Survey Overweight Global Equities

AAI Total Stock Allocation vs Net % of BofA Manager Survey Overweight Global Equities

Source: Bank of America Merrill Lynch Survey, Bloomberg

Both the US fiscal (post-debt ceiling resolution) and monetary impulses (in terms of the Fed’s balance sheet size) are picking up again. In the short term, the flow-on impacts of a pick-up in government spending and/or an expanded monetary base can find their way into asset prices. When both are pointing in the same direction, even better. It doesn’t quite marry up with declining market expectations for inflation, mind you.

The New York / New Jersey Port Authority is kind enough to track monthly traffic volumes across its bridges and tunnels. On a seasonally-adjusted basis, 2023 is shaping up to be an encouraging year with volumes tracking those of 2022, with no leading contractionary indications just yet:

Figure 8: Port Authority (NY & NJ) Traffic Volumes

Port Authority (NY & NJ) Traffic Volumes

Source: Bloomberg

The FTR Trucking Conditions Index shows an improvement in sector conditions including volumes, capacity utilisation, fuel prices, cost of capital, and bankruptcies. We also note anecdotal evidence of supply chains tightening for the first time in a while. Could the inventory destocking cycle be over, leading to a pickup in New Orders in the ISM survey?

Expectations of broader Chinese stimulus as it starts looking increasingly like Japan in the early 90s (high aggregate debt levels, a property market dislocation, falling birth rates, and an aging population). The market has been calling for stimulus, with the Chinese currency weakening steadily in 2023. With open borders once again, China will be looking to stem currency outflows and one way to do this is to change the domestic growth narrative.

As always, one can find a data point to fit their narrative.


We’d argue it doesn’t really matter if equity markets or bond markets are right this time, it’s more about positioning a portfolio no matter the outcome. An appropriate asset allocation for your age / financial requirements, as well as diversification, are long-term factors that will be far more important than the relative performance of stocks versus bonds in the next six months. That said – and in our completely unbiased opinion - the bond market is right more often than it is wrong!