Yield Curve Inverts: Head for the Hills?

The stock market tanked on Wednesday, August 14 because the yield spread between the 10-year US Treasury bond and the 2-year Treasury note turned negative. Such an inversion of the yield curve is widely viewed as a reliable leading indicator of economic recessions. In fact, it is one of the 10 components of the Index of Leading Economic Indicators. But so is the S&P 500, which remains close to its recent record high but would fall sharply if stock investors become convinced that a recession is imminent.

Not only did the stock market react badly to the latest yield curve inversion, but so did President Donald Trump who tweeted: "CRAZY INVERTED YIELD CURVE! We should easily be reaping big Rewards & Gains, but the Fed is holding us back."

An inverted yield curve has predicted 10 of the last 7 recessions. In other words, it isn't as accurate a predictor of economic downturns as widely believed. It can be misleading, having given three false signals of a recession.

In our recently published study "The Yield Curve: What Is It Really Predicting?," we concluded that inverted yield curves do not cause recessions. In the past, they’ve predicted credit crunches caused by Fed tightening. So investors on the lookout for a recession should instead pay attention to credit availability. Recession-watchers should keep an eye on bank credit metrics—specifically, net interest margin, charge-offs and dividends, and business loans. Right now, those metrics aren’t signaling a credit crunch. In our study, we observed:

“One widely held view is that banks stop lending when the rates they pay in the money markets on their deposits and their borrowings exceed the rates they charge on the loans they make to businesses and households. So an inverted yield curve heralds a credit crunch, which inevitably causes a recession. …The widely held notion that a flat or an inverted yield curve causes banks to stop lending doesn’t make much sense. The net interest margin, which is reported quarterly by the Federal Deposit Insurance Corporation (FDIC), has been solidly positive for banks since the start of the data in 1984.”

Credit remains amply available. The Fed has been back in easing mode since the end of July, when the federal funds rate was cut by 25bps. Fed officials are likely to respond to the inversion with more rate cuts.

Our study includes a “Primer on the Yield Curve,” based on “Dr. Ed’s” book Predicting the Markets (2018). It also includes several useful charts for gleaning more insights into the relationships of the yield curve to the economy and to financial markets.

Now available on Amazon in Kindle and Paperback formats.

Dr. Ed is one of LinkedIn's 2018 Top Voices in economy & finance. Institutional investors may sign-up at https://lnkd.in/eYNwch8 for a trial to his research service. His book, Predicting the Markets, is on Amazon.