Hey everyone kevin here, so are we going into a recession? Almost every youtuber or financial media outlet is saying, that's it. The 10-2 has inverted and don't worry. If you don't know what that means. I'll give a brief explanation on that and they're saying: that's it.

We're definitely going into a reception circle, the wagons, because folks there's nothing. We can do anymore every single time in the past that the 10 year and the two-year treasury curve has inverted, we've been screwed and we've ended up going into a recession. But there are three things that can actually explain an inverting yield curve. One could be, the fed has lost all potential faith by markets, number two could be, we are going into a recession and number three could be.

This is what you would expect to happen in this market, and then, of course, there are going to be hints and tools that we could use to tell us which one of those three scenarios is likely to play out. That is is. Is this just a sign that people don't believe the fed anymore? Is this the sign we're going into recession, or is this what you would expect to happen? So, let's break this down. First and foremost, when we consider the 10-year and the two-year yield curve, we have to understand what those things individually represent.

First and foremost, if you had ten thousand dollars - and you said to the government - hey, i'm gon na give you ten thousand dollars. Just pay me interest, while i lend you that ten thousand dollars and at the end of let's say ten years for a ten year treasury bond, give me my ten thousand dollars back and the way this would work. Is you take about ten thousand dollars and the government might say: hey we'll pay you two and a half percent or two hundred fifty dollars per year for ten years, which is great because that's two thousand five hundred dollars, and that would mean that you have earned Two thousand five hundred dollars on top of your ten thousand dollars. For ten years now you can buy and sell this bond, but basically that's what the the ten year bond is right.

If you get two and a half percent for the ten year, then what? If you only agreed to lock up your money for two years well, you would expect to get paid less money, maybe only 180 per year for two years, because at the end of those two years you could take your ten thousand dollars back and you could go. Do something else with it right, so you would expect to get less money because you're taking less market risk, locking your money up for less time again, you can buy and sell these bonds, but if you don't hold them to duration, you're, subject to market risk and That means, if other people, all of a sudden, are selling the two-year bond like crazy the value of your bond. If you were to sell it plummets and that's really really bad if you're holding that two-year bond right. So, assuming you want to hold these two duration, the full term, you would then of course expect that maybe a one year would only pay you like one percent, because again you're taking less risk, so you would expect to get paid less so why? Why would it then make sense ever for potentially, instead of getting paid two and a half percent on the 10 and one and a half or 1.8 percent for the two? Why would it ever make sense for all of a sudden the 10-year yield to be 2.5 per year and, let's just say, i'm going up a little bit higher than what is actually happening right now, let's say the two years, paying you three percent.

Why would that make sense that you're getting paid three percent for the two year and only two and a half percent for the ten would make sense? If you want the value of your bond to maintain some value over the next two years and you're investing in two-year bonds during a time in which other investors are actually selling the two-year bond, because if you get a lot of people selling the two-year bond, that's Gon na lower the price of that bond and anybody holding that two-year bond is going to lose money. If they want to trade it people don't want to lose money, so, in other words, people right now in the market are having to be compensated. A higher amount in order to take the risk on the two-year bonds. So why is that? Well, there are a few reasons and the big predictor tends to be okay.

Well, when the two-year is getting paid more in yield than the 10-year, and that's a sign that we probably have a bad market coming up within the next 12 to 24 months right, i mean look at the past times that the yield curve has inverted. We had an inversion right before the paul volcker era right in the late 1970s and early 1980s. We had some ugly recessions in both circumstances. Here, in fact, on st louis fred, we see two plotted recessions demarked by those gray bars.

You see the inversion here in about 88.89 at a recession right after that in the early 90s. You see an inversion over here in about 2000 and, of course, the dot-com bubble recession, another inversion over here in about 0-6. And what do you get the great recession? You get an inversion over here in 2019 and, oh, my gosh sure was a pandemic caused recession, but he's still at a recession, and so here we are again inverting again. That makes us feel like looking at just this chart that crap.

This is a sign. The market is pricing in that we can have a poopy-doopy economy in a year to 18 months to a year, and a half and people who are investing in two-year bonds want to be compensated more for taking that risk. Okay. So because, if we're in a recession, bonds will probably sell off, stocks will probably sell off.

So that makes sense. We probably aren't able to anticipate that we'll be in a recession in 10 years right. So we're not going to go out to the 10-year and all of a sudden demand much more money for that, because we think we'll be through whatever turmoil we're right now. So that's usually how the 10-2 works, but wait a minute wait a minute.

What, if the reason, we're seeing the two-year demand such a high premium is because we're actually on an aggressive interest rate hiking path. What that means is we believe that interest rates are going to be about two percent by 2023, so let's actually write down that right. Now, in 2022 and q1, 2022 we're at 0.25 for the fed's interest rate, but what if in q, uh 1 2023 interest rates are actually at 2.25 and then in q1 2024 interest rates are three percent. Well, if those are what the fed's interest rates are, then you better be demanding a big fat premium for those two year bonds, but wait a minute.

Do we actually think the fed's going to have rates this high? This long? No, in fact, most estimates say that by q1 2025 we're actually going to see those interest rates. Maybe come back down, maybe back down to two percent, where the fed relaxes the interest rate hiking cycle, assuming that eventually the supply chain issues, repair themselves and inflation goes down so in this dynamic. If we actually draw this out, let's draw this we're very, very low right now we're going to go very, very high within about two years, then we'll probably begin a loosening cycle and head back down and what's very interesting about this is close to us. That is like the closest bond we could get to us is going to be a really short-term bond right, like maybe a three-month bond right, the one that probably aligns most with the peak of the fed's rate, hike, cycling, uh rate hike cycle is the two year Which means the one that has the most market risk is the two year and the 10 year, or even the five year are probably way way way out there at the end of the curve right, let's just go with the tenure for now.

So now you realize, based on the fed's rate, hike cycle, that you're going to have to demand a big big big premium in interest rate for that two year, because you're going to be having that two year at a time when the market, if you needed to Sell this bond has high interest rates, and the value of your bond could be very, very low. If again, remember this, if you lock in a bond a two year bond to two and a half percent, but the fed's at three percent. Well, the two-year bond on the market might actually be trading for like three or four percent interest. That means yours at two percent is worthless, like literally worthless you're, taking a lot of market risk right.

So this is interesting because in the prior chart we saw that a recession is always predicted by this 10-2. But if we now consider have we had an era where the 10-2 has inverted, during which time we also expected in a really weird way, that interest rates would go up for a couple years peak and then come down see in the late 70s. We thought inflation was entrenched, that inflation was going to stay forever and we had to go through a nasty recession to actually get that inflation out. But the market's actually pricing in to some degree that the fed's going to be right.

Then inflation is going to come under control, but wait a minute. Let's go back to those. Those three things that i mentioned could happen number one. We could have a recession that is a proper predictor of the 10-2 right.

We could also have a loss of faith in the fed god of faith and we could have normal market dynamics. So while i wrote this a little bit of it out of order, we talked about number one, the chart showing we should be seeing a recession right. We actually also talked about number three that it would make sense that you're demanding a higher rate for the two year, given the fed's rate height cycle path. But what about the third potential? Well, the third potential is this: the chart here that fed rate hike cycles that don't end in recession are actually quite rare.

That is almost every time the fed raises rates over here in the early 70s over here in the early 80s over here in the late 80s over here in the dot com era over here in the great recession period and, of course, over here uh and going Into about 2018-19 ended up leading to that 2020 recession right, those are all instances where the feds started hiking and at some point we hit recession. Interestingly, we usually hit a recession when the rates kind of start trending down or when the rates peak, which is very interesting, like you see that right before 08, that sort of peak you see that right before the dot-com era, you see that right before the 89 Recession, so it's almost like the fed has to go to its go through its rate hike cycle during the rate hike cycle, the economy's still growing like crazy. It's actually still growing great. That's why they're hiking, because we're almost growing too fast, they stop hiking and it's the point when they stop hiking that you're actually potentially closest to a recession, because that's when they're, like oh okay, yep we're achieving our goal, we're slowing the economy! Ah crap we slow too much recession.

Now there have been two cases over here in the mid 80s and uh over here in the mid 90s, where the fed was able to do what's known, as have a soft landing to stick the landing to raise rates and then lower them without having a recession. It's just more rare than not, and so that's potentially why markets are saying yeah now ten two is inverting because we are going to see a recession. So if we go back to this chart over here or this right down here, this loss of faith in the fed and recession, this is almost one and the same. The markets are saying: uh yeah, no, we're gon na have a recession, but it also entirely makes sense, based on the fed rate hike cycle path, this time that normal market dynamics would invert the ten two curve and that, yes, i hate this phrase.

But yes, this time could be different, but wait a minute. We don't just want to be blind and say: oh this time could be different. I mean come on like when we talk about this kind of stuff in our courses. I always talk about.

Hey you've got to have your eyes open to all the potential different scenarios and the indicators that would tell you which path that you're on, and so let's try to understand which path we're on now and how that maybe compares to different paths. Paths - and this is what you got to pay attention to inflation expectations. That's it. I know that sounds crazy, but there are two ways you can measure this one.

You measure inflation expectations by consumers. Number two. You measure inflation expectations by looking at the five year treasury break. Even if the line on the five year break even is going down.

That means inflation. Expectations are going down. The last week, they've actually been going down. The inflation expectations for consumers are ironically anchored right.

Now they were not when we got paul, volcker and remember going back to this chart right here, how i told you that the three month would probably not see as much of a premium as the two year. Here's another curve that you could pay attention to. It's called it's also another recession indicator and it's on this chart right here. It's called the 3 10 yield.

Look at this. All of the curves are inverting the 5's tens, the twos tens, the tens thirties, like all these longer term ones, are showing some form of inversion. But what's this a very popular predictor of recession, the three month tenure is actually not predicting a recession. In fact, it's going entirely the opposite direction.

Why? Folks? Well? Because this curve right here this path that we're on of rates going up and then rates expected to come down? We haven't seen before in the past, we've seen inflation expectations out of control. We've believed that oh no, the fed's, gon na rate, uh hike rates and then they'll never come down again, but now the market's already pricing in this decline, and so in other words we pay attention to that three-month tenure. We pay attention to the inflation expectations and yeah the inversions and the other curves might deepen, but some of these inflation expectations remain anchored. Maybe maybe there's a chance.

We can actually avoid a recession so again pay attention to inflation expectations by consumers by inflation, expectations in the market by the five year break, even and then, of course, pay attention to a wage price spiral possibly happening. Last labor report said again: no wage price spiral 4.8 percent year over year or my month, over monthly annualized right, big deal and uh number four of course cpi, month over month. So we got ta pay attention to all of this anyway, thanks so much for watching we'll see you next time.