Gold, Silver, Copper Hit by Higher Rates, Stretched Positioning, Bias Remains to Buy Dips

Economic

Commodity

Summary:

Metals markets finally succumbed to the higher rates, stronger US dollar environment, with vulnerabilities evident earlier in the week finally materialising. But the underlying factors behind the rally have not gone away, making us inclined to continue buying dips.

An unfriendly environment for commodity markets right now

The US dollar strength we anticipated this week has materialised, creating headwinds for commodities which has had been rallying on renewed hopes for rate cuts from the Fed this year. The pullback in copper we warned of last week has played out, even if we got the timing marginally wrong. Silver and gold, the former sitting at extremely overbought territory earlier in the week, have also come under pressure.

Following Wednesday's rout, this note will look at the near-term outlook for the US dollar and interest rates, allowing traders to use the framework and apply it to the technical setup for gold, silver and copper on the four hourly charts.

Fed rate cut pricing is evaporating, not growing

For all the headlines earlier this week about commodity prices surging on renewed Fed rate cut hopes, pricing was moving in the complete opposite direction with the Fed funds 2024 curve stripping out 10 basis points of expected cuts from the levels seen last Thursday. That saw Treasury yields out the US curve back-up, seeing two-year note futures fall through a key level that has acted almost like a dividing line between ‘higher for longer' and ‘rate cut hopes' sentiment for months.

Gold, Silver, Copper Hit by Higher Rates, Stretched Positioning, Bias Remains to Buy Dips_1

We discussed the importance of this level during a TV interview on Wednesday, cautioning the higher rates environment should assist US dollar strength and curtail risk appetite among investors, including in the metals markets which were already looking vulnerable.

With the assistance of hawkish central bank commentary from the Reserve Bank of New Zealand and in the minutes of the Fed's FOMC May meeting, along with a UK inflation report that was way too hot to see the Bank of England cut interest rates nest month, it came as no surprise to see the violent pullback in gold, silver and copper given how fast and hard they had run.

Start of something more sinister?

The question now is whether the bullish trend is over or has it simply paused for now? With very little top tier data to look at this week, it's meant Fed members have had to toe the line on the higher for longer rates narrative, likely explaining the rebound in US Treasury yields and the US dollar. However, the US economic wobbles that dominated discussion last week have not disappeared with downside misses in Citi's closely watched economic surprise index now within a whisker of being the most negative in nearly two years.

Gold, Silver, Copper Hit by Higher Rates, Stretched Positioning, Bias Remains to Buy Dips_2

Should that trend continue, it points to only a limited lifespan for this latest bout of higher US yields and stronger US dollar, and an environment conducive to commodity price strength unless it coincides with a deterioration in the global economy.

So, to answer the question posed above, the answer is likely a pause in the metals rally, not start of a longer-term rout. And that means we're in the market to buy dips. Eventually.

Gold offers decent trade setup

Turning to gold, having tumbled through support at $2408, the price bounced from the intersection of uptrend and horizontal support at $2375 in the North American session, providing a useful setup for those eager to reset longs at improved levels. Those considering taking on the long trade could buy at these levels with a stop below $2375 for protection, targeting a bounce back to $2408.

While tempting, with price momentum to the downside, I'm in no rush to move in quickly, preferring to wait to see whether the price can hold these levels for more than a fleeting moment. Because if can't, a break below $2375 also generates a decent short setup, allowing for shorts to be initiated below the level with a stop above for protection. Aside from potential bids around $2355, there's not a lot of visible support evident until $2332.

Gold, Silver, Copper Hit by Higher Rates, Stretched Positioning, Bias Remains to Buy Dips_3

Silver slump already encouraging dip-buyers

Silver is another interesting setup on the four hourly chart, breaking minor support at $30.95 on Wednesday but not really going on with it. The downside wicks provide clues that there's still willing buyers around, making a potential reversal back through the level a decent prospect on Thursday. If the price obliges, buy with a stop below the low of $30.72 for protection. On the topside, there's not a lot standing in the way towards a move above $32.

However, we must acknowledge the price momentum remains to the downside. If silver can't bounce back through $30.95, traders could consider selling with a stop above the level for protection. Uptrend support around $30.25 would be the first port of call with a break of that opening the potential for a deeper flush towards $29.79.

Gold, Silver, Copper Hit by Higher Rates, Stretched Positioning, Bias Remains to Buy Dips_4

Copper bears finally get their way, for now

To copper, and it too has seen a decent pullback, with large sellers camped above $5 eventually getting their way. While the price action has been undeniably bearish recently, such is sentiment towards the red metal, it's difficult to see pullbacks much larger than what was seen on Wednesday.

While price momentum remains to the downside, those keen to buy dips now could initiate longs around these levels with a stop order below $4.746 for protection. Preferably, a push back above $4.813 makes for a better trade setup, allowing for a tight stop to be placed below the low of $4.78 targeting a push back towards $5.02.

Gold, Silver, Copper Hit by Higher Rates, Stretched Positioning, Bias Remains to Buy Dips_5

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Samantha Luan

Central Bank

Economic

Federal Reserve officials earlier this month coalesced around a desire to hold interest rates higher for longer and “many” questioned whether policy was restrictive enough to bring inflation down to their target.

Minutes from the two-day Federal Open Market Committee gathering ending May 1 showed that, while participants assessed that policy was “well positioned,” various officials mentioned a willingness to tighten policy further if warranted.

“Participants noted disappointing readings on inflation over the first quarter,” according to the minutes released Wednesday in Washington. The minutes showed “that it would take longer than previously anticipated for them to gain greater confidence that inflation was moving sustainably toward 2%.”

Officials also discussed holding rates steady for longer “should inflation not show signs of moving sustainably toward 2% or reducing policy restraint in the event of an unexpected weakening in labor market conditions,” the minutes said.

Following a first-quarter pickup in inflation, Fed officials have said they will hold interest rates at a 23-year high for longer than initially anticipated.

Chair Jerome Powell said at his May 1 press conference that it’s clear monetary policy is restrictive and that over time he expects the current level of rates to bring inflation down to the central bank’s 2% target. He added it was unlikely the Fed’s next move would be a hike.

“We’ll need to be patient and let restrictive policy do its work,” he reiterated at an event in Amsterdam on May 14.

The minutes offered a more nuanced picture. Though officials viewed policy as generally restrictive, policymakers pointed to the possibility of high interest rates having a smaller effect on the economy than in the past. They also said the long-run neutral rate — a level of rates that neither slows nor stimulates demand — may be higher than previously thought.

“Many participants commented on their uncertainty about the degree of restrictiveness,” the minutes said.

Atlanta Fed President Raphael Bostic said Tuesday that officials at the US central bank are holding active discussions about the neutral rate, adding “everyone is rethinking that dynamic.”

Latest Inflation Data

Since the Fed’s meeting, April consumer price data showed a modest cooling in inflation following three months of higher-than-hoped readings. While price growth remains above the Fed’s goal, the latest figures alleviated some concern that it was reaccelerating.

Governor Christopher Waller welcomed the better inflation data in comments earlier this week but said he’d like to see several more good reports before lowering rates. He further distanced the Fed from potential rate hikes, instead opening the door to lower borrowing costs at the end of this year.

The minutes do seem “somewhat inconsistent with the press conference,” said Torsten Slok, chief economist at Apollo Global Management.

The economy continues to grow at a solid pace, though recent reports on retail sales and manufacturing suggest demand is easing. The labor market remains resilient but is also showing signs of cooling. Payrolls rose at the slowest pace in six months in April.

A softer inflation report for April and somewhat slower pace of hiring in April “validates” the higher for longer message Powell talked about in the press conference, said Stephanie Roth, chief economist at Wolfe Research.

Investors are betting on one to two rate cuts this year, according to futures markets. While that view is similar to many forecasters, others expect more or less. Goldman Sachs Group Inc. Chief Executive Officer David Solomon said Wednesday that he predicts “zero” cuts in 2024.

Officials voted to slow the pace at which the central bank is shrinking its asset portfolio at their latest meeting, reducing the cap on runoff for Treasuries to as much as $25 billion from $60 billion starting in June. Investors had generally expected the cap to fall to $30 billion.

The minutes showed almost all participants expressed support for the new cap, however, a “few” officials supported continuing the current pace of runoff or a higher cap on Treasuries than was decided on.

Source：Bloomberg

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Glendon

Economic

The GBP/USD currency pair has been making waves recently, defying expectations and consolidating its position above the key resistance level of 1.2750. This bullish momentum has investors glued to their screens, eager for the next move. This article delves into the technical analysis of the GBP/USD pair, explores relevant news impacting its value, and examines whether the Pound Sterling is poised for a further climb towards parity with the US Dollar.

Technical Analysis: Bullish Signals Flashing

The recent price action on the GBP/USD chart is painting a bullish picture. Here's a closer look at the technical indicators:

Moving Averages: The 50-day and 200-day moving averages are currently trending upwards, indicating a positive overall trend for the Pound.

Relative Strength Index (RSI): The RSI for GBP/USD is currently at 62, suggesting that the pair is not yet overbought, leaving room for further upside potential.

Support and Resistance Levels: The key support level for the pair sits at 1.2700, with the recent consolidation acting as a strong confirmation. The next major resistance level is 1.2850, a break above which could signal a significant bullish move.However, it's important to acknowledge that technical analysis alone doesn't paint the whole picture.

News Roundup: A Mixed Bag for the Pound

Several recent news events are impacting the GBP/USD pair:

Weakening US Dollar: The US Dollar (USD) has been under pressure lately due to fading recession fears and positive earnings reports from major US companies. This weaker USD naturally bolsters the Pound Sterling in comparison.

UK Inflation: The UK Consumer Price Index (CPI) inflation data for April is due for release soon. If the data shows a decline in inflation, it could boost confidence in the Pound, as the Bank of England (BoE) might be less likely to raise interest rates aggressively.

Geopolitical Tensions: Global geopolitical tensions can create uncertainty, leading investors to seek safe-haven assets like the USD. While there haven't been any major escalations recently, the potential for future events should be monitored.

GBP News: BoE Stands Pat on Rates

The Bank of England (BoE) recently decided to maintain its current interest rate policy, surprising some analysts who predicted a hike. This decision indicates that the BoE might be adopting a wait-and-see approach, allowing them to assess the impact of recent economic data on inflation before making any adjustments.

USD News: Focus on Upcoming Fed Meeting

The US Federal Reserve's Open Market Committee (FOMC) meeting in June is a major event on the horizon for the USD. If the Fed signals a more hawkish approach with aggressive interest rate hikes, it could strengthen the USD against the Pound.

Expert Opinions: Cautious Optimism for the Pound

Financial experts are cautiously optimistic about the Pound's future. Some analysts believe a breakout above 1.2850 could pave the way for a further rise towards parity with the USD, fueled by a weaker Dollar and potentially lower inflation in the UK. However, others warn that geopolitical tensions and the Fed's monetary policy decisions could still disrupt the Pound's momentum.

What to Watch Out For

Investors should keep a close eye on the following developments:

UK Inflation Data: The release of April's CPI data will be crucial for gauging the BoE's future policy decisions and its impact on the Pound.

US Fed Meeting: The outcome of the FOMC meeting and any signals regarding future interest rate hikes will significantly influence the USD and subsequently impact the GBP/USD pair.

Technical Chart Signals: A clear breakout above or below key support and resistance levels on the GBP/USD chart will provide stronger technical direction for the pair.

Conclusion: A Positive Outlook with Underlying Risks

The current outlook for the GBP/USD pair is cautiously optimistic. Technical indicators suggest a potential rise, and a weaker USD is providing tailwinds. However, the release of upcoming economic data and the Fed's policy decisions remain significant factors to consider. Investors are advised to monitor the evolving situation and conduct thorough research before making any investment decisions related to the GBP/USD pair.

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Glendon

Economic

The New Zealand Dollar (NZD) is flexing its muscles against the US Dollar (USD) this week, extending its rally and surpassing the key resistance level of 0.6150. This bullish momentum comes as the NZD/USD closed at 0.6172 on May 27, 2024, representing a 2.3% gain compared to the previous week's close. Let's delve into the factors propelling the NZD/USD higher and explore what lies ahead for this currency pair.

China's Stimulus Package: A Tailwind for the Kiwi

The primary driver behind the NZD/USD's recent surge appears to be positive news emanating from China. The Shanghai government, a major economic hub accounting for nearly 4% of China's GDP, recently announced a series of stimulus measures aimed at bolstering the struggling property market. These measures include subsidies for homebuyers, tax breaks for developers of up to 50% on property taxes for qualified projects, and relaxed mortgage restrictions, allowing a down payment as low as 15% for first-time homebuyers in certain circumstances.

China is a critical trading partner for New Zealand, with China importing over 60% of New Zealand's dairy products and being a significant market for timber and other commodities. A resurgent Chinese property market could lead to increased demand for these exports, bolstering the NZD.

US Dollar on the Backfoot: Risk-on Sentiment Takes Hold

Adding fuel to the NZD's fire is the current weakness in the USD. The greenback has been under pressure lately as risk appetite returns to the market. Investors are becoming more comfortable with riskier assets like stocks and commodities, leading them to pull funds away from the safe-haven USD. The US Dollar Index (DXY), which measures the USD's strength against a basket of six major currencies, currently sits at 92.7, down from a high of 94.5 in early May 2024.

This shift in sentiment can be attributed to several factors, including:

Fading Recession Fears: Recent economic data, such as a stronger-than-expected April jobs report showing 275,000 new jobs added, and comments from Federal Reserve officials suggesting the US economy might be on a more solid footing than previously anticipated, are reducing concerns about a potential recession.

Earnings Season Optimism: Positive earnings reports from major US companies, with the S&P 50 posting average earnings growth of 8.2% for Q1 2024, are boosting investor confidence, further weakening the demand for the USD as a safe haven.Technical Analysis: Bullish Signals Emerge

The NZD/USD price chart is also painting a bullish picture. The pair's recent breakout above the 0.6150 resistance level is a positive technical indicator. Additionally, technical indicators like the Relative Strength Index (RSI) are currently at 62, suggesting that the NZD/USD is not yet overbought, potentially leaving room for further upside.

Looking Ahead: Key Factors to Consider

While the current outlook for the NZD/USD is positive, there are still factors to keep an eye on:

China's Economic Recovery: The effectiveness of China's stimulus package and the overall health of its economy will significantly influence the NZD's future trajectory. If the stimulus measures successfully revive the property market and boost broader economic activity, it could be a boon for the NZD. However, any signs of faltering in China's recovery could dampen the NZD's momentum.

Federal Reserve Policy: The Federal Open Market Committee (FOMC) meeting in June will be closely watched. The Fed's monetary policy decisions, particularly regarding future interest rate hikes, will impact the USD's value and subsequently influence the NZD/USD pair. The pace of future rate hikes will depend on incoming economic data and inflation readings.

Global Risk Sentiment: Overall risk appetite in the global financial markets will continue to play a role. A resurgence of risk aversion, perhaps triggered by geopolitical tensions or unforeseen economic events, could see investors flock back to the USD, potentially weakening the NZD.

Conclusion: A Positive Outlook with Cautious Optimism

The NZD/USD's recent rally is encouraging, fueled by positive developments in China and a weaker USD. However, the future direction of the currency pair will depend on a confluence of economic factors, policy decisions, and global risk sentiment. Investors should remain cautious and closely monitor these key drivers before making any investment decisions.

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Cohen

Commodity

Economic

A flurry of speculation by futures market traders has pushed prices of metals such as copper and gold to all-time highs, as funds bet on upcoming shortages in supplies and try to hedge against inflation.

Copper has rallied 30 per cent since the start of March to break through $11,000 per tonne this week, its highest level ever. That has helped lift the prices of other industrial metals from aluminium to zinc.

The rush of investor buying has also pushed gold through its previous records to hit $2,450 per troy ounce and silver has followed to exceed $30 per ounce for the first time in a decade.

There have been “stark investment inflows” into metals from algorithmic traders, specialist commodities investors and macro funds, said Greg Shearer, head of base and precious metals strategy at JPMorgan.

The moves in metals prices have frequently defied traders’ expectations. Last year strong demand helped deplete inventories to historic lows, yet prices dropped. This year, prices have rallied, even though supplies are improving. Rush of Fund Manager Interest Drives Metals Prices To Fresh Highs_1

Rush of Fund Manager Interest Drives Metals Prices To Fresh Highs_1

Commodities’ share of global markets has been shrinking, meanwhile, dropping to 2 per cent over the past 12 months from 8.8 per cent in 2009, according to Bloomberg data, as equities and bonds have raced ahead.

“The market was kind of ignoring everything from a fundamental perspective,” said Ricardo Leiman, chief investment officer at KLI Asset Management, a London-based commodities investment manager.

Analysts said the moves were driven by a surge in open interest — the number of open futures positions and depth of the market.

Open interest across base metals and precious metals markets reached record highs of $227bn and $215bn respectively last week, according to a JPMorgan analysis.

This largely consists of funds closing their bets on falling prices and those taking long positions to profit from price moves, rather than producers or consumers hedging against the risk of price movements when buying or selling commodities, analysts said.

Net investor long positions on Comex and the London Metal Exchange for base metals were 2.6mn tonnes in the middle of May, up from 556,000 tonnes at the beginning of March, eclipsing the previous high in late 2020.

The wave of money hitting metals has come not only from momentum-driven algorithmic traders but also from macro hedge funds boosting their allocation to real assets and specialised commodities hedge funds, analysts said.

Copper, which is the most vital to the process of decarbonisation, has led the surge in prices. Shearer said a “very hard to fix supply picture” underpinned copper’s rally.

“For copper, the tightening supply picture times the possible [artificial intelligence] demand uplift and more comfort that we’re at an inflection point for global demand, plus inflation hedging, has been a potent brew,” he said. “That has made a lot of funds say ‘now is the go-time for copper’.”

Rush of Fund Manager Interest Drives Metals Prices To Fresh Highs_2

Other base metals such as zinc, aluminium and lead have followed copper, jumping between 15 per cent and 28 per cent since the start of April in a sharp collective swing higher.

Aline Carnizelo, managing partner of Frontier Commodities, a newly established commodities investment vehicle, said investors wanted to diversify their returns beyond big technology stocks by turning to metals.

Funds are putting money behind commodities to get exposure to “decarbonisation, deglobalisation, a hedge against inflation and geopolitical risks as well as the under-investment in new supplies, particularly of energy”, she said.

Inflows to broad-basket commodities funds — including grains, minerals, metals, cottons and cocoa — have been rising in the past few months, more than doubling in April to £1.9bn, according to Morningstar data.

Despite weaker than expected demand in China and a rapid build up of metals stocks, there have been signs that global manufacturing is finally turning a corner, which has also helped fire up interest in silver, given its extensive use in solar panels. China’s purchasing managers’ index expanded for a second consecutive month in April after half a year of contraction.

Australian mining group BHP’s £34bn approach to buy rival Anglo American to secure its coveted copper mines in Latin America also sent a further signal to investors to snap up the red metal, investors say.

“The BHP takeover woke up a lot of people that it is much cheaper to buy a company than building a new mine,” Leiman said. “It triggered a lot of people to unwind positions and for [computer-driven trend-following hedge funds] and some of the macro crowd to go long. There has been a massive reorganisation of flows.”

A net 13 per cent of global fund managers surveyed by Bank of America were overweight commodities in May, the most since April last year. The past three months had the largest increase in their allocation to commodities since August 2020, according to the survey.

Some top hedge funds have been increasing their commodities trading teams to take advantage of the volatility in the asset class. Family office BlueCrest Capital is planning to expand its number of trading teams, including in commodities, by 10 per cent by the end of the year.

Commodities have typically traded based on their current supply and demand situation, but Carnizelo said the increasing role of speculative investors in the market means they are starting to trade based on the likely future picture.

“It’s starting to get commodities to behave a bit like equities,” she said.

Source:Financial Times

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Samantha Luan

Economic

In April, 5.23% of subprime auto loans were 60 days or more delinquent, the worst April on record, and a hair above the prior record of April 2020.Subprime delinquencies were already rising from 2015 through 2019, as subprime lending was getting very aggressive. Investors earn high yields on the riskier lower-rated portions of the ABS that take the first losses, and those yields compensate investors for taking those credit risks, though it may not always work out.

Subprime doesn't mean “low income,” it means “bad credit”; it means a history of taking on too much debt and not paying those debts and other obligations as agreed, which caused their FICO score to drop into the subprime category.

And subprime auto loans are getting into trouble after the free-money era got them temporarily out of trouble. In April, 5.23% of subprime auto loans were 60 days or more delinquent, the worst April on record, and a hair above the prior record of April 2020, according to the Fitch subprime index, which tracks auto loans that have been securitized into the asset-backed securities (ABS) that are rated by Fitch.

The index is seasonal, with highs every January or February and lows in April or May, as tax refund season bails out many a borrower. February 2024 had been the highest of any month on record, with a delinquency rate of 6.4% (red). But prime auto loans are in pristine conditions (blue).

The Aprils of every year going back to 2006

Subprime delinquencies were already rising from 2015 through 2019, as subprime lending was getting very aggressive, leading to a slew of scandals, big losses, and the collapse of some PE firm-owned specialized subprime dealer/lenders in 2018, some of which we discussed at the time, so we're kind of used to the subprime drama and take it in stride.

The thing is, subprime is a business with huge profit margin on selling the cars, and huge profits on financing the cars at dizzying interest rates, and so specialized companies take big risks to get to those profits, and for some, it ends in a collapse when the risks come home to roost.

Subprime is only a small part of used vehicles, doesn't impact new vehicles

With auto loans, nearly all subprime lending is for used vehicles, and most of it is for older used vehicles. The sweet spot is around 10 years old. It's very difficult to finance a new vehicle with a subprime credit score.

About 61% of used vehicle buyers pay cash, according to Experian. For the 39% who borrow to buy a vehicle, the share of subprime borrowers was about 14% of loan originations. This means that about 5.5% of all used vehicle buyers (those that pay cash and those that finance) get subprime loans. It's just a small specialized high-risk, high-profit corner of the overall used vehicle market.

The subprime share used to be higher before the pandemic, a sign that subprime lending has tightened in 2023, as it always does when delinquencies pile up.

Prices and the mess

But used vehicle prices spiked by about 55% in 2020 through 2021, and people took out big loans to finance these massively overpriced used vehicles. Since early 2022, used-vehicle prices have given up nearly half that spike, but they're still very high, and interest rates have shot up. These movements have turned the used-car business upside down.

A few PE firm-owned specialized subprime dealers/lender chains collapsed in 2023, and the largest publicly traded subprime dealer/lender Car-Mart disclosed big problems, and its stock tanked nearly 50% since mid-August, despite the booming stock market.

Losses for investors have been less severe

The subprime business hinges on the dealer/lender being able to securitize the subprime auto loans into Asset-Backed Securities (ABS) and sell the investment-grade tranches of those ABS to pension funds and other yield-seeking institutional investors, and sell the riskier junk-rated tranches that take the first losses to investors seeking higher yields.

Fitch's Auto-Loan Annualized Net Loss Index for subprime loans has come up from the free-money lows but has not reached new highs, and has remained in the pre-pandemic range, which is kind of surprising, and led Fitch to speculate that there was a rotation of delinquencies, where delinquent borrowers, when they got closer to losing the vehicle, resumed payments at the expense of some other debt, such as credit cards, rotating between them.

They're in essence juggling their delinquencies to stay in a position where they can keep their cars, which has helped keep the losses in the normal range.

Investors earn high yields on the riskier lower-rated portions of the ABS that take the first losses, and those yields compensate investors for taking those credit risks, though it may not always work out.

This subprime mess powered the overall delinquencies

According to the New York Fed Household Debt and Credit Report this week, the 30-day-plus delinquency rate for all auto loans – so 30 days, not 60 days as the Fitch index – rose to 7.9% in Q1, the highest since 2010, and about half a percentage point higher than in 2017. Many of the borrowers who are 30 days behind eventually start making payments again and don't reach the 60-day stage that Fitch tracks:

The auto debt burden is high, due to high vehicle prices

Surging vehicle prices have caused vehicle debt to surge, and the debt levels have roughly kept up with rising disposable income over the past few years, and the ratio remains high.

Note that about 80% of new vehicle purchases and only about 41% of used vehicle purchases are financed, so for people who do finance, the burden can be substantial.

Where the problem arises – as we have seen above – is in the subprime segment where cars are sold with huge profit margins, and therefore at very high prices, and massive payments in relation to what customers are getting.

Disposable income is income from all sources except capital gains, minus taxes and social insurance payments. This is the income that consumers have left to spend on car payments and all their other stuff:

Source: Wolf Street

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Thomas

Economic

When the US Treasury yield curve inverts (short rates rise above long rates) the shift is widely viewed as a reliable forecast that a recession is near. But this time has been different, or so it seems. The curve has been inverted since July 2022, the longest inversion on record, but a recession has yet to arrive.

Is the yield curve no longer relevant for business-cycle analysis? Or is this widely-followed signal just slow this time? Actually, it's neither, explains Robert Dieli, an economist at NoSpinForecast.com, a business-cycle consultancy.

In a series of email exchanges with CapitalSpectator.com, Dieli outlines his views on the yield curve, of which he is a veteran analyst on behalf of his clients. “The last four recessions started after the yield curve inversion was resolved,” he advises. “The signal is not when the curve inverts. The signal is when the curve goes back to its normal shape.”

In the following Q&A, Dieli shares additional thoughts (and charts) on the art/science of interpreting the yield curve for business-cycle analysis.

Q: What set of Treasury yield maturities do you prefer for monitoring the curve?

A: My criterion for whether we have an inverted yield curve is the yield on the 10-Year Treasury Note minus the current level of the Federal Funds Rate. In both cases I use the monthly average of each metric. I use the Fed Funds rate because the FOMC has complete control over its level and trend, which means that the duration and severity of a yield curve inversion are largely at their discretion. I use the 10-Year Note both because it has the longest continuous issuance history of the long-maturity securities (both the 20-Year and 30-Year Bonds have had gaps in issuance) and because it is currently the flagship rate in the bond market.

What is the track record for recession warnings for the yield curve when it normalizes after a period of inversion?

This chart shows the record of yield curve inversions going back to 1955. As you can see, we did not have inversions under my criterion, until the mid-1960s. The next two charts address the question you just posed.

Is The Yield Curve Still Relevant? An Economist Clarifies_1

Is The Yield Curve Still Relevant? An Economist Clarifies_2

During the period between 1955 and 1987 the curve inversions persisted into the recession periods. Note also that we had a period that I have marked as the “soft landing” where we had an inversion of the curve that was not soon followed by a recession. This was the episode in which the FOMC succeeded in slowing the economy almost to the point of a downturn and then eased policy. History strongly suggests this was a bad move since what followed was one of the most volatile periods of inflation and monetary policy.

Is The Yield Curve Still Relevant? An Economist Clarifies_3

Since 1987, which appears on both charts because Alan Greenspan replaced Paul Volcker at the Fed in August of that year, the inversions have ended either shortly before or shortly after the official business cycle peak dates. Keep in mind the location of those dates was set well after the changes in monetary policy took place. The FOMC did not know exactly where the cycle peaks would be when they changed policy.

The LTCM note on the chart refers to the Long-Term Capital Management failure, which required that the FOMC cut rates as part of the resolution of that crisis. This was not an analog to the soft landing we saw on the prior chart, which was an attempt to regulate macroeconomic activity through monetary policy. LTCM was a rescue and recovery mission.

One final point to note is that through the entire period covered by all the charts, the inversions usually start during periods where the Funds target is rising and always end during periods where the Funds target is falling. Which is another way of saying that the cycle peak signal is when the Funds target begins to fall, not, as some would have it, when the Funds target starts to rise.

What is the yield curve telling us these days about the state of the US economy and the near-term outlook?

Two things. First, the FOMC is applying restraint and is, therefore, expecting to see economic reports that reflect the effects of that restraint. In particular, a diminution of the rate of inflation.

Second, with the FOMC currently in what appears to be the pause phase of its “pause and pivot” strategy, we should be alert for the signals that will tell us they are satisfied as having applied enough restraint and thus begin to pivot.

Is the yield curve alone sufficient to monitor business cycle risk? If not, what other indicators are on your list and what are they telling us at the moment?

It would be nice if there was just one indicator we needed to follow to monitor business cycle risk. Unfortunately, such is not the case. The yield curve is attractive for many reasons. First, the data are available in real time. Second, the data are never revised. Third, it is simple to calculate regardless of which set of interest rates you use. Fourth, it is sufficiently arcane to allow you to sound smart. But it is not enough by itself.

I have three other metrics that I look at along with the yield curve.

The first is the year-over-year percent change in the Index of Industrial Production, which is published by the Federal Reserve and is part of the package used by the Cycle Dating Committee of the National Bureau of Economic Research, the official arbiter of dates for business cycle peaks and troughs. While manufacturing does not play as large a role as it did back in the day, the health of that sector correlates very strongly with the overall health of the economy.

The second is the six-month moving average of the year-over-year-percent change in private payroll employment. (Say that fast six times!) That series has dipped below 1% in front of every cycle peak. Right now, it is running at about 1.6% and has been in a downtrend for the past year.

The third is the spread between the inflation rate and the unemployment rate. As we have approached cycle peaks in the past, the inflation rate has gone above the unemployment rate ahead of the cycle peak. We have that condition present today.

Having an inverted yield curve, flat manufacturing activity, slowing employment growth and the inflation rate higher than the unemployment rate suggests a level of instability that would facilitate the formation of a business cycle peak. Whether we get one will depend heavily on how, when, and why the FOMC executes its policy pivot.