Inverted Yield Curve: Understanding Its Implications

by: Bill Cara

Most traders have a sense that an inverted yield curve is not a good thing for the economy. If commercial lenders lose money when borrowing short and lending long, then sooner or later either there is no money for us to borrow or else the bank gets broken.

The Federal Reserve is soon going to set the new overnight lending rate to commercial banks. If the Fed Rate is raised, then that’s a clear sign that the Fed wants the commercial banks to stop lending to speculators.

The bond market is quite a different animal to the Fed. While the Fed sets rates, the bond market sets prices that result in yields. A yield is not a rate.

A changing yield has different implications if the yields rise or fall across all maturities or relatively more or less at the short-end or the long-end. This dynamic movement is referred to as the Living Yield Curve because it’s always in motion.

The slope of the yield curve is quite important because that’s the evidence as to how bond traders see the health of the economy.

If you are bullish on the U.S. economy, bullish on the equity market, you ought to be wanting a positively sloping yield curve.

Unfortunately, that’s not the case today. Whether or not the whole curve rises or falls relates to inflation concerns. The curve rises and falls within a limited range most of the time. But, when the whole curve rises quickly and to the extreme, that’s a sign of inflation concern on the part of bond traders; when it falls quickly and to the extreme, there is an overriding deflation concern.

Presently, the whole curve is rising, which is signalling inflation. But, the 3-Month T-Bill yield is rising faster than the 10-year Treasury Note yield, which is indicating that bond traders are concerned about a slowing economy.

This is a Stagflation scenario that doesn’t often happen. The last time I saw it like this was in the 1970’s. And, yes, during the 1970’s there were bull cycles in equity markets and bear cycles, but they were muted. That’s one of the reasons I have been ultra-cautious in my trader mindset whenever equity prices move well above normal trend, as is the case today.

In the 1970’s there were also bull and bear cycles in commodity prices, and these were extreme. At the end of the 1970’s, in fact, the bond market got so concerned with inflation that bond prices had collapsed and yields were up near 20-pct.

In fact, in Canada, in order for the federal government to sell its Savings Bonds, there was the need to place a 15-pct coupon on the issue. That’s enough to bankrupt a nation, so governments are really concerned about the possibility that inflation could return like that again.

And where did that bond money go in the latter 19070’s? Well, it couldn’t go into equities so much because high interest rates and oil prices (yes, we had an oil price crisis in 1977 as I recall) were killing corporate profits, so it went into speculation that would hopefully keep the investment return above the cost of capital.

So first there was a strong housing market until prices got to where there was no economic return from rents or capital gains from resales; then the real estate prices collapsed. Sound familiar?

Then the money went into precious metals and collectibles. Same thing is going to happen today because corporate profits are not going to yield economic returns in the future unless costs (interest rates, oil, labor) come down and revenues increase.

In this period of adjustment, the investors who hold long positions in over-priced stocks are drum-beating their future prospects. They want you to assume the great risk (of potential capital loss) that right now they are holding. So there is an element of pump and dump going on today.

All this is clear to me, so I have advised to sell off very high-priced assets, and to get into a defensive mindset. In particular, I have advised setting higher stop prices, and to carefully watch the technical support levels in equity markets that people like Colin Twiggs offer you.

It is possible of course that the economy does turnaround 180 degrees, and that equity prices have fundamental reasons for rallying, but rather than listen to Dream Merchants mislead you on this important point, why not check out the chart data for yourself, and make up your own mind?

The most important topic is the yield curve. Aussie technical analyst Colin Twiggs does a good job of providing insights into the inverted yield curve topic and what that means to recession probabilities.

Twiggs discusses a paper by Jonathon Wright of the Federal Reserve entitled “The Yield Curve and Predicting Recessions,” which is an important part of the literature. Download Paper on the Wright Model (.pdf).