Yield Curve, Unemployment, and Sunspots

Fed Chairman Jerome Powell stated in his August 23, 2024 Jackson Hole speech that it is time for the Fed to change its stance on interest rates.  He all but guaranteed that the FOMC would be cutting rates at its Sep. 17-18, 2024 meeting, although of course he did not say by how much.

So why is this happening now?  There are two big reasons for this timing.  The first has to do with rising unemployment, as depicted in the chart above.  The U.S. unemployment rate has a very strong positive correlation to the spread between 10-year and 1-year T-Note yields.  So because the unemployment rate is rising now from its April 2023 low of 3.4% to now 4.3% as of July 2024.  And not surprisingly, the 10-1 spread is rising with it.

Part of that rise is a direct effect of changing expectations about what the Fed will do.  The 1-year yield is tied pretty tightly to other short term rates, which go up and down in sympathy with the rate that the FOMC sets as the target for overnight loans among member banks (known as Fed Funds).  So as bond market investors view a changing likelihood of a Fed rate cut, they will adjust the prices they pay for T-Bonds, T-Notes, and T-Bills, and the yield changes as a consequence.

Another part of that rise is that as the economy slows (pushing up unemployment), companies have less need for capital to invest in expansion of plant and equipment or new hiring.  So a reduction in competition for money to borrow means that the price (yield) of that borrowing goes down.

The second big reason for the timing of this change by the Fed is far more fascinating, and will be more difficult to accept for classically trained economists who think that humans and governments are in charge of everything.

The same 10-1 yield spread which correlates really well to the unemployment rate also correlates well to the monthly sunspot count.  The key to seeing this, though, is that we have to shift forward the sunspot count data plot by 3 years to see that correlation.

The sunspot count started rising for this cycle in early 2021.  So counting forward 3 years takes us to where we are right now in 2024.  Past experience suggests that the yield curve should move toward its normal positive relationship, and should keep moving that way until about 3 years after the sunspot cycle reaches its peak, which has not happened yet.

This correlation is not perfect, though, and there have been significant anomalies in the past.  A few of those anomalies are highlighted in the chart above.  The important point to understand, though, is that an episode like Covid or the 1973 oil embargo can throw the yield curve off the ideal path for a while, but then rates get back on track again afterward.  The same was true for when Greenspan kept rates too low, fueling the real estate bubble, which led to the 2008-09 Great Financial Crisis (GFC).  Eventually, things got sorted out, and the correlation returned.

It is normal to wonder why sunspot numbers would be related to bond yields.  It is a natural human inclination to want to know the "why" behind a phenomenon.  But knowing the "why" is not essential for seeing the "is".  We have enough years of history showing that this relationship is real, even if one cannot explain it.  I will note that in other research I have done, I have linked the sunspot cycle to Pacific Ocean temperature anomalies, and Atlantic basin hurricane numbers.  The sun's variability has a big effect on climate, and so if anyone wants to go hunting for the linkage to interest rates it is probably there.

This relationship will not tell us exactly what numeral rates will apply for the 1-year and the 10-year yields.  It only tells us about the path that should be taken by the spread between those two.  If you have enjoyed this most recent yield curve inversion, then you can look forward to having an inversion again in around 2034, which is 11 years after the 2023 extreme point for this current yield curve inversion.  But for the next few years, you can look forward to short term rates being in their more normal position, i.e. lower than long term rates.  And you can also expect that a weaker economy will be the reason for that.