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Some Thoughts On the Inverted Yield Curve

The waning predictive powers of the inverted yield curve

For decades, one of the most accurate measures for predicting a recession has been when short-term yields on Treasuries exceed those of the longer-term bonds. Many believe the yield curve is a reliable indicator of an upcoming economic downturn. This is becasue the short-term side of the yield curve is mainly driven by Federal Reserve policy that refleccts current economic strength; the long-term side of the yield curve—10-year and longer matiurity Treasuries, by comparison, is thought to indicate bond investors’ long-term views of the market as well as inflation expectations.

An inverted yield curve has preceded each of the last seven recessions as measured by the National Bureau of Eonomic Research.

As such, whenever the dreaded inverted yield curve rears it’s ugly head, investors understandably start to panic. Over the past year, the yield curve has inverted several times — albeit for very shot durations. Is a recession imminent if the curve inverts for a few days? Is there a minimum duration for which the yield curve must be inverted prior to a subsequent recession, that may follow anywhere between a few months to two years.

What part of the yield curve one looks at matters as well: is the comparison between the three-month bill and 10 year note the definitive standard to

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Prof. Campbell Harvey of Duke University analyzed inversions in the 1980s and concluded that the 10-year/three-month relationship or correlation, was the best part of the curve to use. For those investors who panic the instant an inversion occurs, he also concluded, that it needs to be inverted on average over a quarter to provide a solid signal, not just for a few days—let alone just part of a day.

Could the inverted yield curve no longer be a reliable indicator of an imminent recession? in th is regard, it is instructive to note that a number of factors that were not present during the past seven recesssions. First, interest rates were certainly not at the historically low present levels when the curve inverted. In this regard, Ii is perhaps interesting to note the 10 year Treasury bond yield recently dipped below 1.25%, the lowest it has ever been.

The bull market of the past decade was in large part fielded by the massive quantitatie easing policy of the Federal Reserve. The Fed arguable, kept the money supply spigot open for fa too long. As a result, interest rates have remained at historically unprecedented low levels. Because of the extended duration of the of the Fed’s easy money policy, investors becam acclimated to historically low rates and their expectations were that rates would remain perpetually low. This proved to be a boon for the stoc market as the return on fixe-income investments was negligible. Not only did the Fed keep interest rates relatively low, European central banks went a step further and continued their quantitative easing, so much so, that the Continent has had negative interest rates for the past several years.

The unprecedented negative interest rates on sovereign bonds around the globe could be one of the reasonss why short-term Treasurey yields exceed long-term rates. Additionally, investors expectations for inflation are certainly not the saame as they have been for the past thirty years. Indeed, there are those who argue, that the days of rampant inflation of the Volcker era are over. Inflation has stubbornly remained below the Fed’s 2% rate for the past three quarters. The persistent low levels of inflation could be another factor that could help explain the recent yield curve inversions.

There have been mixed signals concerning the health of the economy: consumer spending and confidence remain high, even if manufacturing capacity is starting to taper off. The market is uncertain as to which direction the economy is headed. It is important alos to remember, the Fed has very little room fo cut rates further. That raises another issue: will negative interest rates start to appear in teh United States?

Another factor that has been determinative of the Fed’s interest rate policy has been the reaction of stock market to any bad news on the trade front or the prospect of slowing global growth, that may ultimately impact the U.S. economy. The Fed, in a very real sense has been a hostage of the stock market. When it did an abrupt about-face in January and shelved its plans for another interest rate hike in the face of a market meltdown, Fed chairman Jerome Powell, though he won’t admit it, is overly solicitous of investor sentiment and wishes for rate cuts.

This is another determinative factor that impacts the level of short-term and long-term rates.

All of these factors need to be taken into account when one attempts to divine the future direction of the economy from an inverted yield curve.

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