Beware of the Inverted Yield Curve!
In the movies, an edgy musical score is an effective tool that warns the audience something really bad is about to happen. Like the shrill screech in Psycho, certain sound effects forebode impending doom. In like manner, economics also has a similar warning sign of imminent market chaos. This omen is called the inverted yield curve. And it’s no coincidence that the last seven recessions have been preceded by this ominous predictor of economic and stock market disaster.
The yield curve graph depicts the slope of sovereign bond yields across all maturities. When investors desire to purchase longer-dated maturities, they typically demand a higher yield to compensate for inflation risks that tend to increase over time. Therefore, under normal circumstances, longer-term bonds yield more than their short-term counterparts. Typically, the yield on 30-year Treasury bonds is three percentage points (300 basis points) above the yield on three-month Treasury bills. When the yield curve steepens from that usual spread it means long-term bond holders believe the rate of inflation will increase sharply in the future.
At the other end of the spectrum we have the inverted yield curve. This occurs when the Fed Funds Rate and short-term U.S. Treasuries offer higher yields than longer-dated issues. The signal here is that investors anticipate an environment of sharply slowing economic growth, deflation, and economic turmoil.
How This Played Out During The Past Two Recessions?
By the late spring of 2000, the rate on the 10 year note was lower than the Fed funds rate; thus officially inverting the yield curve. The Federal Reserve raised the Fed funds rate 25 basis points on March 21st from 5.75, to 6.0%. Afterwards, the Fed ended its rate hike campaign in May of that year with a 50 basis point rate increase to 6.5%, while the Ten-year Note traded below 6.0% by June. After this, the S&P 500, which was not a part of the tech bubble, peaked in July of 2000 and dropped 40% by September of 2002.
Likewise, in June 2006 the Fed ended its multi-year cycle of rate increases, taking the Funds Rate up 25 basis points to 5.25%, while the 10-year Note yielded around 5.0% during that same timeframe. The yield curve officially inverted for the second time that decade-investors once again heard the ominous music playing. The backward yield curve first caused the massive housing bubble to rollover in the summer of 2006. And, since the yield curve remained inverted for over one year, the equity market quickly followed the collapsing real estate market. The S&P 500 plummeted 50% from July of 2007, to March 2009.
Last week the 10 year note was trading around 2.25% and the Fed Funds rate was in the 0-25 basis point range. During the Fed’s previous rate hike campaign, it had to move short-term rates up 400+ basis points before the yield curve became inverted. However, this time around the Fed will only have to increase the Fed Funds Rate half that amount before the yield curve will become inverted. And it may take even less than that, as the economy is already experiencing anemic growth and disinflation-which will put downward pressure on long-term rates. In addition, interest rates on foreign sovereign debt are well below those in the United States, which will push domestic rates down even further.
Therefore, this time around the yield curve will invert at a much lower level than at any other time in history. What’s more, the Fed has historically raised rates in order to combat a rising rate of inflation, a weakening U.S. dollar and rapid GDP growth. Now, it will be raising rates in the midst of low inflation, a soaring Greenback and anemic economic growth. And, the Fed won’t have to make many rate hikes before the yield curve inverts.
So Why Will The Fed Raise Rates?
The Fed has drawn a Maginot line with its use of the unemployment rate as the main indication of when to raise rates. The Fed is relying on an indicator for when to raise rates that is painting an inaccurate picture of growth and inflation. The U-3 unemployment rate, which is now sitting at 5.5%, isn’t taking into account the unusual amount of part-time and discouraged workers. That U-6 unemployment rate, which includes those partially and fully separated from the workforce, is currently 11%. That figure is two full percentage points higher than where it was the last time the U-3 rate was at this level, which was during the epicenter of the financial crisis.
But the Fed’s Keynesian illogic dictates that a low unemployment rate is the very cause of all that is inflationary, despite alternative measures of labor slack. Therefore, in Pavlovian fashion, it will feel compelled to start raising rates in the next few months.
Most importantly, it will be raising short-term rates when the long end of the yield curve has been artificially manipulated to a record low level. Our hapless central bank may be venturing down the short and dangerous path to an inverted yield curve. But at the same time, economic growth and inflation are decelerating.
Interest Rate Obsession
Foreign central banks will also soon have to abandon their reckless policies of QE to infinity due to its futile effect on GDP growth. Likewise, since sovereign yields are near zero percent in Japan and Europe, it will take just a few basis points in rate hikes to send the entire developed world into an inverted yield curve situation for the first time in global economic history. This is what lies ahead for global investors as central banks begin to move away from the massive distortion of asset prices for the last 7 years. Unfortunately, in the aftermath of this next deflationary collapse, global governments will embark on an unprecedented economic experiment that will involve the further erosion of free markets as part of their effort to reflate asset prices.
In the movies, when a character is unaware of the ominous warning signs that the director has provided the audience, it usually leads to their imminent demise. Ms. Yellen and company may be unaware how important an inverted yield curve is to the banking system and money supply growth. But investors should not let the ignorance of central banks lead to the demise of their wealth.