The Inverted Yield Curve's Back and This Time It's Worse

by: David Andrew Taylor

It's happened again, and this time it's likely to be for real: The inverted curve.

There were a great number of pundits out there saying that the inverted yield curve was NOT a harbinger of bad times ahead. They were right. At the time, job growth was moderately strong and GDP was firm. Consumption by Ken and Barbie, although beginning to slow, was still firm at the malls. Inflation was under control and short-term interest rates were lower by about .75 basis points. Confidence was up and the equities markets were moving in the same direction.

Now where are we?

Short term interest rates are pushing higher and will likely go to a range that I will term "too far" tomorrow. Job growth has become anaemic with the latest release of the 75k increase in new jobs. GDP has moderated in the first quarter but has since grown back to what could be full capacity. However, this lagging indicator may be discounted as evidence of slower, more timely data is beginning to show strains on the growth rate. Inflation? That stuff is growing on trees if you ask the current Fed Board, and short-term interest rate increases are the cure.

Way back several months ago, the inverted yield curve did not predict a recession as it often does. The economy did not enter one since that time. Easily discounted, but give the pundits credit: They were right for about six months. Now, however, with looming short-term interest rate increases likely to couch any real growth in both the economy and inflation, investors are entrenching their appetite for risk. Equities are looking as if they've recently peaked. The same short-term interest rate increases have also slowed the cash registers ringing of consumers shopping habits. The consumer, the ultimate bastion of economic petroleum have seen the rate of growth in their incomes decline and consumption on a whole is following suit.

Aaron Smith from the Dismal Scientist ($$$) put together a chart that helps show the inverted yield curve along with their analysis:

My Outlook:

With tomorrow's rate increase as well as the wording remaining relatively the same from the previous statement, the Fed will overshoot and this yield curve will invert even more. The Fed is going to word their statement so that they don't paint themselves into any corner at all. The Fed is very data dependent and will want to wording to say that at any moment if inflation gets too loud, so will our hawkish statements.

If inflation comes under control, then the Fed will apply the "yet" policy and not make any moves.... but will still be watching with weary eyes. The mere threat of this is going to be enough to knock around any economic imbalances to the point of tipping over down the road to a recession.