The Yield Curve Inversion Warns Investors

The yield curve is warning of tight monetary conditions that have led to recession conditions in the last seven economic slowdowns. The 3’s and 5’s inverted for the first time in this 10-year recovery cycle. What is not widely understood by investors is that the Fed’s balance sheet reduction program is putting downward pressure on long bond prices, which would tend to mask a broader yield curve inversion. 

We would suspect the selling pressure forced into the treasury market by the Fed’s balance sheet reduction is pushing up yields on 10’s through 30’s. If the Fed was not shrinking their balance sheet, yields on longer duration treasuries might be lower leading to inversion on the longer end of the curve. The additional quantitative tightening from balance sheet reduction is not only distorting the yield curve but is probably the proximate cause of the fast-paced move to surprisingly weak economic conditions in the U.S. 

The recent comments from Chair Powell and the Fed indicate they have been caught off guard by how fast economic data has been deteriorating. People fail to realize that balance sheet reduction and Fed tightening has never occurred in tandem before. The historically weak economic recovery from the Financial Crisis and the lack of strong growth further compounds the U.S. economic system’s ability to absorb the impact of rate hikes. 

During this hike cycle, the Fed has raised the federal funds rate eight times from 0.25% to 2.25% — an 800% increase. It’s likely they will hike again in December to 2.50%, driving the total increase to 900%. The magnitude of these hikes is unprecedented and could be another reason the economy is faltering quickly. As a counterpoint, the Fed raised rates from 2004-2007 by 425%, enough to not only slow the economy but lead to the Financial Crisis. 

Yield inversion has been a good predictor of economic and market trouble ahead, and we believe yields would be providing a much more powerful inversion signal if the Fed’s balance sheet reduction was not weighing on bond prices. Sometimes it’s hard to see the forest when you are surrounded by trees, but recent market turbulence, weaker economic data, and today’s yield curve inversion indicate investors should be very careful with their capital in the months ahead. 

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