What About That Inverted Yield Curve?

by: David Andrew Taylor

I got a reader question over the weekend in a comment regarding the Understanding the Coming Recession piece that I did last week. In it, Barry asked what the fundamental reason was behind their being a recession and the inverted yield curve. Was it a function of where interest rates were at the time, or was it a function of the inversion itself?

On that, I'll defer to Tom Graff who wrote a real nice piece on the inverted yield curve, why it inverts, and what it means.

Tom had this to say about the yield, and I agreed:

I think the Fed is down playing the inversion to serve their own purposes.

Basically, the short term rates are too high based on the market's perception of where the economy is heading. The market believes that short rates are heading lower. As Tom ponders:

So if long-term rates are lower than short-term rates, than means that the market widely anticipates falling short-term rates. Why would short-term rates fall? Because the Fed is cutting. Why would the Fed cut? Because the economy stinks.

I feel about the same. But, I may be looking at this a little differently than Tom. I believe that short-term rates are likely to head higher in the medium-term, then lower. I think the Fed is going to find themselves in a situation where they haven't moved interest rates enough and aggregate demand is still pushing inflation higher. They'll want to fix this problem. Then, the economy will... as so eloquently expressed by Tom... stink.

Thanks for the comment, Barry.