Hey guys, it's Sasha In early July Last year, the yield curve inverting. and if you don't know what that means, the consensus out there seems to be that this is really bad. Since 1978, there have been seven yield curve inversions. The average time from the inversion to the next recession has averaged 16 months.

You have an inverted yield curve. You're getting really treasuries at a five percent yield, close to a five percent yield. Look at the yield curves I mean that If you take that message seriously, they're telling us we're not just going into recession, but we're going into a deep one. It seems that everyone has decided that this inverted yield curve is a guaranteed prophecy of Eternal Doom The argument goes something like this: Every single time the yield curve has inverted.

it was followed by a recession. And of course, every time you have a recession, there's bad news for the stock market. People lose their jobs, they don't have money to spend, nobody's buying goods and services the economy goes to. and so of course only a complete idiot would stay invested in the stock market when they yield curve.

inverse I Get a ridiculous number of comments on every video recently telling me that I am the idiot because I did not mention the yield curve inversion in my analysis and look, the data is irrefutable every time it. inverse. Aeros Session follows. So let me show share some thoughts with you on why I Do not care whatsoever what the yield curve is doing first.

just so that we are on the same page, the yield curve is the chart of the yields that you can get on U.S Government treasuries ranging from the shortest to the longest term. Usually that chart looks like this: If you are the government and you want people to give you money for a longer period, you have to pay more in interest. Otherwise, why would anyone lock their money away for a longer period, a longer period of time when there is more risk and more uncertainty? The yield on these treasuries is a function of the Market's demand and Supply So if lots of people want to buy a treasury, the yield on that treasury. Falls Because if lots of people are queuing up to buy the thing, you don't have to pay as much interest in order for them to go and buy it.

If the demand Falls then the yield goes up because if fewer people want to buy the treasuries, then you have to incentivize them more by increasing rates. Now, sometimes this chart flips and it goes the opposite way. The way people normally measure this is by taking the difference between the 10-year Treasury and the two-year Treasury and plot that chart and almost always this difference is positive. That's the normal if you like yield curve, but every now and then you can get more interest on a two-year treasury than a 10-year one.

And when that happens, the yield curve inverse and the difference becomes negative. You can see that in the last 30 odd years this has happened in 2000, just before the.com crash in 2005. Two to three years before the financial crash, the yield curve kissed a zero percent line in 2019 because of course investors knew that covet would arrive in 2020 and the yield curve is now strongly negative. In fact, this is the lowest has been in 42 years, Which incidentally is interesting because 42 years ago is when the last time that we had an inflation Spike happen.

That was the time when inflation in the US ran all the way to 15. the FED stopped increasing rates too early, and then Paul Volcker had to hike them all the way to 20 to stop the US economy down the path of the Weimar Republic with wheelbarrows for carrying your wallet. The obvious question when talking about the yield curve is, why does the yield curve have this habit of preceding every recession? Well, the answer is that the yield curve is a voting mechanism for the Market's confidence in the risk profile of the future. Usually the market is relatively more certain about what they expect to happen in the short term.

You have a lot more confidence about what's going to happen tomorrow than you do about what's going to happen in 10 years time. So when you're pricing risk over a 10-year period, you have to build in a natural uplift to account for all the unknown risks that could happen in that time frame. So when you see an inverted yield curve, the market is saying that it thinks the risk in the short term is worse than the risk of the unknown in the long term. At least that's the accepted narrative.

So the market is saying that it expects to hit the fan any minute now, but it probably will get better in the future. So the yield curve inverted in February 2000. The peak of the stock market was almost two months later in March 2000. The mark can really start to Tanki from that summer onwards, and an official recession came a year later in 2001.

Then the yield curve inverted again in February 2006, and it was yo-yoing around that zero percent line. The stock market peaked a bit later in October 2007 almost two years later, and the recession came immediately after that. So you can already see the first problem with the yield curve. Its prognosis seems to have a lag of anywhere between a couple of months and three years.

So while the popular thesis is that the inverted yield curve means the recession in 2023 is guaranteed using this approach, that recession could as easily come in 2024 or in 2025. But here is the real issue Here is the chart of the two-year treasury yield. and here are two things that you need to look at. The first is that the overall long-term trajectory is down the way the central banks manage debt.

The way that the economies are structured has fundamentally changed in the 42 years since 1981.. the public understanding and perception of what government debt actually is and how it isn't really the same sort of debt that you or I might have that has also changed, the yield on the government debt has fallen as a result. Some people may make the argument that this is because we have had a way too good for too long, that yields have fallen to artificially low levels, and it's all going to implode. But the more probable argument here is that we are seeing a fundamental shift in the long-term cost of debt for governments In the world where countries don't tend to disappear or get conquered as often as perhaps they used to.

and even when countries Fall Apart like the Soviet Union or join up like Eastern West Germany, there is an established precedent of countries retaining their debt and continuing to honor payment obligations. Anyway, the other thing to notice on this chart is that the yield since the financial crash have come to sit just above zero, and the recent increase is the first time in history when interest rates started increasing not from some starting number like four percent, but from basically sitting at zero percent for a decade. So so one interesting posit is whether there is a unique Market sentiment because of the sharp increase in rates last year from a zero percent starting point, because you could structure an argument, the market can see that the FED has just hiked rates by another quarter of a percent a few days ago to a range of 4.5 to 4.75 and the expectation is that in the short term, those rates ain't coming down and the yields should therefore stay elevated. But remember, inflation peaked last summer at pretty much the same point when they yield curve inverted and you could equally structure an argument that there is a building of expectation that in the longer term, the US government will be reducing rates and yields and treasuries will come back down.

So when you're valuing 10-year bonds, you may expect a lower rate environment during the latter part of that period, which would naturally invert the curve. The same phenomenon would not happen in previous cases where the curve inverted because the relative increase in yield compared to the starting point was much lower. So risk was the dominant factor in determining long-term bond yields. But just because this is how the yield curve relationship played out in the past does not necessarily mean that this is how it has to follow in the future.

There is no good reason why the supply and demand of the treasury market can be driven also by other factors such as expectations on short-term versus long-term yields instead of risk. This is the first inversion where the stock market is already full of stocks on discounts. So when investors are making decisions on where to park their money, short-term bonds will also be under pressure from discounted stocks, and this would naturally reduce demand for bonds, because if you believe that there are some stocks out there that are undervalued now that the prices have come down on some of the biggest companies by a lot, presumably you may think that your return on those stocks may be in excess of the four percent or whatever that the bond will pay you. This is the first yield inversion where this quandary has appeared and remember that this is the first sustained stock market drop since the rates went to 0 in the first place.

So we have the first situation where investors have had to make a decision on whether they want to park their money in bonds for periods of two years or ten years, or if they want to invest in stocks that have seen a big drop in price when the yield curve inverted in February 2000. The stock market had been on the biggest bull run in history right up to that point and had not yet peaked when a yield curve inverted in 2006. The stock market almost doubled in three years out of the.com Crash and was still going up for a year and a half after the inversion. There was no Market drop in December 1988 either, and by the time the yield curve inverted in July last year, the stock market was already down 20 percent in the six months before that.

So in terms of predicting a stock market full, this particular yield curve conversion is a little late to the party, and it's happening in an entirely different way to every previous inversion. It's the first time the inversion happens after the crash has started. It's the only inversion that happened following a long period of zero percent interest rates. US GDP grew by 2.9 in Q4 after growing 3.2 percent in Q3 Which means we're probably at least a couple of quarters away from a recession being declared if it actually does come.

So how much of that recession has already played out? How much of it has the stock market already priced in by Falling all the way through last year? And after pricing it in, is the stock market now looking forward 18 months instead of looking backwards, because remember, in each of these previous inversions, 18 months later is roughly on average where the stock market started falling. But if we're looking at a scenario where 18 months down the line, the market is on the way back up, for example, this is what the analysts would now be trying to forecast, then maybe if that was the case, this whole yield inversion curve is not quite the end of the world that everyone is making it out to be. If making investing decisions was as easy as looking at one chart to predict a crash 100, then guaranteed every single time it would be pretty cool because everyone will be able to perfectly time the market and become a billionaire. And I know that there is this stigma attached to any thesis or any conversation that starts with.

This time is different because you know keyboard Warriors like to posture on social media, write comments like said, he didn't know what you're talking about you so dumb. But the simple fact is there is a lot of nuance when it comes to the yield curve inverting, as there is with most macroeconomic things, it could be followed by another crash just like what happened before, but it could just as easily not. And just because you flip a coin three times and it lands heads three times in a row does not mean that it is a slam dunk that that coin will land heads on the next flip as well.