How much does the inversion of the yield curve really matter?

How much does the inversion of the yield curve really matter? Analysts seem divided on this issue. On the one hand there’s no doubt that historically when the yield on short-term US treasuries rises above that on long-date 10-year bills, a recession has never been far away.

This time round though, there’s the added complication of 10 years of monetary monkeying around. The world’s propensity for cheap money has grown to the point where it’s now considered normal rather than outlandish.

And that means that the signals which retrospectively indicated that recession was on the way in 2007 and 2008 may not be applicable now.

After all, when you can borrow money from central banks in many jurisdictions for almost nothing today, how much of a predictor can the rate of income on a ten-year debt really be?

Analysts at Wells Fargo certainly give this view credence, at the very least.

Yes, there is an inversion, Wells Fargo argues, but at this point it’s not very big, and previous inversions have widened considerably before they heralded full-blown recessions.

“The recent inversion of the yield curve is not very significant in a historical context, and previous Fed purchases of Treasury securities for its QE program means that the curve is probably flatter than it otherwise would be,” said Wells Fargo.

“The curve would probably need to invert significantly and remain inverted for weeks, if not months, before it would be a reliable recession signal.”

And actually, if monetary policy was operating under normal conditions, the yield curve might not even be there.

“There is some question about the reliability of the yield curve as a recession predictor at present,” the US bank continues.

“The purchase of Treasury securities by the Federal Reserve as part of its quantitative easing program collapsed the term premium on longer-dated Treasury bonds. Researchers at the Fed estimate that the US$1.5 trillion of QE purchases of Treasury securities reduced the term premium about 60 bps. The Fed has subsequently allowed about $300 billion of Treasury securities to roll off its balance sheet, but the yield on the 10-year Treasury security today is still arguably lower than it otherwise would be.”

All of which means that if you do care to ask whether the current yield inversion does indeed herald a recession within the next few months, the answer is: maybe.

Accordingly the markets, with the attention span of a goldfish, took severe fright at the yield inversion, and then within a couple of days had moved on. There’s still the potential uplift of a trade deal between the US and China to look forward to after all, and if it’s true that some major countries in the European Union are teetering at around zero growth at the moment, the US is still powering away.

On the one hand, traders have viewed the Fed’s sudden dovishness on interest rates this year as a cause for alarm. But on the other hand, the view is that the Fed is at least across the problem of the disparity in growth between the US and its major, non-Chinese, rivals.

The trouble is, of course, that it’s not just the yield inversion that’s creating the negative sentiment. Chinese growth is slowing. We’ve known that for some time, but the trend is becoming increasingly marked. This month’s manufacturing figures were particularly poor. Growth in the US is slowing too, although not yet at rates that need cause concern. Japan continues to stagnate, Germany is teetering on recession and Italy is already in one.

What’s more, signs of the continued fraying at the edges of the global economic order continue to make themselves manifest. Italy has signed up to the Chinese Belt and Road Initiative, much to the displeasure of its US and European allies. The Brexit chaos continues, with no end in sight, despite the various deadlines that are presenting themselves.

And President Trump has essentially nullified international law in recognising the Israeli occupation of the Golan Heights. By the same logic, he should also recognise the Russian occupation of the Crimea and the eastern Ukraine. And maybe he will, now that the pressure of the Russia investigation is off.

That all leads to a level of uncertainty that to some extent will discourage investment decisions and hasten further any potential slowdown.

Paradoxically though, it may not be too bad for the dollar, which is why gold hasn’t risen further on this preponderance of negativity. In fact, the Fed is looking like the most resilient financial institution out there at the moment, and that ought to support the dollar quite well.

The corresponding drag on US markets is, at least for the time being, likely to be discounted by the ongoing strength of US economic growth. Which in turn will bring buyers in for the dollar, creating a short-term virtuous circle. How long it will last, remains to be seen.

But if the size and duration of that yield inversion lengthens, then we may be in for a bumpy ride.

Story by ProactiveInvestors