Yield Curve Inversion: Time to Worry?

In a slow news week for the financial markets, the reporters at Bloomberg have made a big deal about yield curve inversion:

Yield Curve
The yield on the benchmark two-year Treasury yield ended the week at 4.40 percent, according to bond broker Cantor Fitzgerald LP. The 10-year note yielded 4.39 percent. An inverted curve, where short-term yields exceed long-term yields, last occurred in December 2000 and has come before each of the past four economic downturns.

The Federal Reserve has spurred the climb in short-term yields by raising the benchmark U.S. interest rate eight times this year to 4.25 percent. Investors are optimistic that policy makers will end their rate increases next year, sparking bigger gains for the stock market. Bloomberg News

There is dispute over the significance of the 2 year and 10 year inversion. Historically, inversion has been measured by the 3 month T-bill vs. the 30 year. That has been the most predictive section of the yield curve for recession. (See this article by Fidelity Fixed Income). Despite this, inversion between 2 and 10 year yields is predictive of slower economic growth, if not recession.

There have been many economists, including Greenspan and Bernake, who argue that "The yield curve is no longer a useful gauge of the economy" (Greenspan's Testimony) The first argument: the notion of a "savings glut" where foreigners buy long term U.S Treasuries, forcing yields down. This is a technical factor that doesn't reflect underlying economic activity.Second, the spread is not wide enough to be statistically meaningful. From the above link:

Statistical analysis indicates that the first factor--the gap between the current and long-run levels of the real federal funds rate--is a key component from which the yield curve slope derives much of its predictive power for future GDP growth. When the level of the real federal funds rate is pushed well below its long-run level, economic stimulus is imparted and the yield curve steepens. The economic stimulus influences output growth with a lag; as a result, the steepening of the yield curve in this scenario is a predictor, albeit not the cause of, stronger economic activity ahead. Conversely, when the level of the real federal funds rate is pushed above its long-run level, economic restraint is imparted and the yield curve flattens. Once again, the economic restraint influences output growth with a lag, so the flattening (inversion) of the yield curve in this scenario would signal weaker economic growth ahead, but would not itself be the cause of the weakening.

Let's put the "savings glut" theory to rest. There is no global savings glut. There is, however, lots of U.S. dollars floating around, looking for a place to park themselves and earn a return. Interest rates around the world have been at historical lows. Just 2 years ago, the Fed was commenting on an "unexpected and uncomfortable" decrease in inflation--(aka. deflation). In order to combat deflation, the government did the following:

• the Fed lowered the Fed funds rate to 1%. Japan has had 0% interest for years.
• In addition, the Bank of Japan (BOJ) and Minister of finance (MOF) created 35 trillion yen, out of nothing, to buy long term, U.S. bonds, forcing down yields in the U.S. Low interest rates in the U.S. sparked a housing bubble, and kept consumer spending strong.
• The president also passed a tax cut, further stimulating the economy
• Ordered the invasion and rebuilding of Iraq, increasing government deficits, further stimulating the economy.

As Richard Duncan, author of The Dollar Crisis observes, the action by Japan alone was "money creation on a scale never before attempted during peacetime."

What has all that money bought? A housing bubble in the U.S, as well as other parts of the world (see also U.K, and Australia, as well as China and Europe). It certainly hasn't done much for stocks. For all of that money and credit creation, since December 2003 the strongest U.S. market--the Russell 2000, has risen at about 10.7% compounded--roughly in line with the long term historical average of the U.S. market. The SP has compounded at about 7% for the past 2 years--below the typical 10% long run return.

The failure of the markets to respond to such massive credit creation tells me we are fast approaching a point where further increases in credit are not going to be able to keep the global economy going. Any slight restriction in credit (ie. a flat or inverted yield curve) will likely signal a sharper than normal recession down the road.

The Chairman's second point, the difference between long and short term yields, is slightly more valid. What needs to be kept in mind is that the best predictor has been a 90 day average of the yield spread. John Mauldin from Save Haven writes:

In September 2000 the yield curve was seriously inverting. I called Estrella to talk about the importance of the curve. I wrote then:

'First, he told me he had done another study in 1998 comparing even more predictors. The latest study involved 30 potential predictors of a recession. The conclusion of that study is that the 90 day average of the yield curve was the most reliable predictor of the 30 they studied, so score one for taking this current situation more seriously."

What message is the Yield curve currently giving? Considering it had inverted during a week of slow trading, there is some merit to holding off on drawing any conclusions until more data from normal trading activity comes in.

What would be a mistake, in my view, is to ignore a sustained mild inversaion, say less than 30 basis points. Those probability charts are based on yield differences, and do not take into account the fact that basis point changes (hundreths of a percent) are more meaningful at lower yields than at higher yields.

As is described in the bond market classic: Inside the Yield Book:

"Common sense says that yields fluctuate according to pecentages of starting yields; that is to say, a yield change from 6% to 8% is as likely as change from 3% to 4%, or that a yield change by 100 basis points from 8% to 9% is less significant and more common than a 100 basis point change from 3% to 4%

The interpretation of the indicator needs to be adjusted to historically low interest rates. If average long term yields are about 7.3% and inversion occurs when short yields are 50 basis points above long yields, that would put a short yield at 7.8%, or 7% higher than long term yields.

At interest rates at these low levels, an equivilent spread indicating recession would be about 30 basis points.

What I expect to see: a sell off in stocks of about 10% the first half of the year. Don't be surprised if the Wall St. cheerleaders look surprised at the weakness with all of the "good" economic data. There will likely be indicatons of a recession in the lagging economic data late in 2006.