An inverted yield curve has historically been the most accurate indicator of an impending or concurrent recession. The inversion during late 2006 and most of 2007 is a good example. Studies have shown that curve inversions precede a recession anywhere from 6 months to 2 years. I would argue that, stripping away the affects of inflation and data manipulation, real economic activity has been somewhat recessionary for several years.
The shelf-life of financial topics is about as long as the lifespan of a mayfly (about 24 hours). Several months ago, a debate raged about the significance of the inverted yield curve (short-term rates are higher than longer-term rates). Most perma-bull pundits who populate mass financial media advised their minions to ignore the yield inversion because "it's different this time."
The inverted yield curve discussion disappeared soon after the stock market responded to the stock market intervention after the Christmas massacre. However, over the past several days, the yield curve has "collapsed" in the sense that yields at the long end (10 years and beyond) have fallen more sharply than at the front end of curve, resulting in a yield curve inversion that is now at its steepest since 2007 (measured using the 3-month T-bill rate vs. the 10-year Treasury yield).
The chart above was prepared by Phoenix Capital (with my edits). It shows the SPX from 1999 to present on a weekly basis vs. the the yield curve (3-month T-bill minus the yield on the 10-year Treasury bond). When the blue line in the bottom panel goes below the black line (the black line is my edit to clarify when the spread between the 3-month bill and 10-year Treasury has gone negative), the yield on the 3-month bill is higher than the yield on the 10-year Treasury.
The chart must have been prepared prior to the holiday weekend because the 3-month/10-year has been inverted since Monday. But more to the point, you'll note that this particular "flavor" of inversion was accompanied by a sharp drop in the stock market from 2000-2003 and from 2007-2009. The yields have been inverted between other segments of the curve (1-year to 5-year, for instance) nearly continuously since last summer. The curve is even more inverted now than when I wrote this commentary for my Short Seller's Journal subscribers last week. The 5-year Treasury is well below 2%. The 3-month/5-year inversion is close to half a percentage point (46 basis points).
In addition, the upper bound of the Fed Funds rate "target" (2.25-2.50%) is now above the entire yield curve out to 10 years. The bond market is signaling to the Fed that the economy sucks and the Fed Funds rate needs to be reduced down to at least 2%. The term "bond market vigilantes" was coined originally by Ed Yardeni in the early 1980s to convey the idea the bond market could be used to "guide" the Fed's monetary policy implementation. The "bond vigilantes" right now are "screaming" at the Fed to reduce the Fed Funds rate and to ease monetary policy.
While the market can't dictate the Fed Funds rate, big bond funds with a total rate of return mission will pile into the Treasury bonds at the longer end of the curve, driving down yields (bond prices rise) in the expectation that the Fed will have to cut rates sooner or later. This is the market dynamic that induces an inverted curve.
Whether or not the Fed will "listen" to the bond market and cut the Fed Funds rate at the mid-June FOMC meeting remains to be seen. To be sure, the researchers at the Fed who advise on policy know that the real rate of inflation is significantly higher than CPI-measured inflation. They also know the economy is reeling. But the Fed has to balance easier monetary policy with setting policy that supports the U.S. dollar.
Maintaining a stable dollar is critical to inducing foreign money to buy Treasuries, the supply of which will soar once the debt ceiling is lifted. If the Fed cuts rates too soon or too quickly, especially relative to the ECB or PBoC, the dollar could experience a not insignificant sell-off. This in turn would cause further damage to the economy.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.