The Inverted Yield Curve and Implications for National Security Investment

(Translation: Economy go down, defense spending go up.)

Inverted Yield Curve May Benefit Defense Spending: The essay argues that focusing on changes in the yield curve, particularly the spread between short-term and long-term rates, might be more insightful for defense investors. Historically, such changes have coincided with increased defense budgets, even during periods of economic slowdown.

Defense Spending Shows Resilience: Regardless of the recessionary implications of the yield curve, the data herein suggests that defense budgets tend to rise during economic downturns, potentially due to government spending as a solution.

In 2021 and 2022, there was a surge in news articles and pundits talking about the inverted yield curve and the impending recession it was foretelling. While a historically reliable recessionary indicator, the current inverted yield curve has not been accompanied by the anticipated economic downturn.

Typically, a yield curve slopes upwards. This means short-term bonds have lower interest rates (yields) compared to long-term bonds. Investors typically demand a higher reward for locking their money away for a longer period. When the curve inverts, short-term interest rates become higher than long-term rates [Ed. Note: meaning you make more money per day the nearer the payback period is – which is insane.] This is a relatively rare occurrence and suggests a weakening economy that the Federal Reserve may need to address by lowering rates.

This pattern has held true for the past eight US recessions. However, the current prolonged inversion contradicts this historical trend, leaving many to wonder, “So when is the beat going to drop?” [for those of you in the author’s age bracket, in this instance “beat” = “likely recessionary economic period.”]

Given this audience, we think a more interesting question is what an inverted yield curve means for the greater US National Security and Defense ecosystem. In that context, changes in the yield curve (i.e., one month change in the 10-year minus 2-year yields) tell a much more interesting story.

Below we show the annual US Defense Budgets from 1960 – 2022.? The blue shaded regions indicate periods of yield curve inversion.?? The trend here aligns with the established behavior of safe-haven assets like Treasuries and utilities which tend to appreciate during periods of economic pessimism (source: Satterthwaite , Chris. Verdad, ‘Changes in the yield curve tell a story even if the current inversion has not’). Notably, defense spending also exhibits similar resilience, suggesting a potential benefit for national security and defense investors irrespective of the recessionary implications of the yield curve.

But what about recessionary periods, specifically? We have previously observed that the US Defense spending tends to increase by ~18.0% year over year during periods of economic recession.

Politics aside, our theory is that the Federal Government really only knows one way out of a problem, which is to try and spend their way out of it.

Campbell Harvey, one of the first academics to publish on the inverted yield curve, put it succinctly in the recent Wall Street Journal article: “It is naive to think that you can just forecast the complex U.S. economy with a single measure from the bond market.”

We have no view on whether the yield curve is a reliable recessionary indicator. But we do think that measuring the trend or changes in the yield curve underscores the fact that when investors allocate capital to the National Security and Defense sector, they are investing in a resilient asset class that – maybe more critically - ?is not sensitive to greater economic cycles.?

In a sense, the US NatSec and Defense industries create a safe haven in more ways than one.

Leonid Capital Partners invests vital capital into critical National Security initiatives. LCP is a US Department of Defense Trusted Capital Provider investing in start-ups, small- and medium-sized businesses across all industries within the United States. Our commitment is to use our cutting-edge approach to fund businesses working on critical National Security work quickly, safely, and reliably.