The yield curve inverted for the first time since ‘07. A classic signal of a coming recession; does it still hold true?

An Inverted Curve

An inverted yield curve happens when short dated bonds yield more than long dated bonds. Wednesday the 2-year Treasury was yielding .01% more than the 10-year Treasury. The Treasury can often be used as a gauge of future gross domestic product (GDP) expectations. That would mean the GDP outlook for the next 10 years would be less than 2%. After inverting Wednesday, it has normalized, but inversions over the last 50 years have indicated a recession looming about 6 months out.

The Federal Reserve Impact

There is reason to believe that inversion does not spell a recession. The Federal Reserve Bank (FRB) lowered interest rates last month after 4 years of increasing rates. The start of a new cut cycle was welcomed by the market and if the market thought the cuts would continue, an inverted yield curve would have been avoided. Had that been the case the 2-year bond would be priced lower, as future cuts would have been expected. Additional cuts were not expected. The FRB said the cut was a mid-cycle adjustment and nothing further should be expected.

The FRB also impacts the yield curve by leaving un-marketed bonds on their balance sheet. By not trading these bonds they are keeping equilibrium. The cost of selling these bonds would be higher interest rates. If the FRB were to dump a large portion of these bonds on the market, we would see rates jump dramatically. So, realistically the FRB could have strategically sold long dated bonds to prevent an inversion. This would have never happened, since the FRB’s mandate is contained inflation and unemployment, not to prevent indicators…

The International Impact

Supply and demand skew the picture as well. German GDP was announced Wednesday morning at a lackluster -0.1%. This prompted the 10-year German Bund interest rate to fall further. When looking at the developed market, bond rates have fallen a great deal:

• Germany 10 yr: -.69%
• France 10 yr: -.41%
• Japan 10 yr: -.23%
• USA 10 yr: 1.57%

If the choices for a safe haven holding were any of the above, a US Bond would be purchased. The resulting demand would mean prices would rise in the US bond market. As bond prices rise their yields fall.

Conclusion

Economic data supports that the economy is not in a recession. Building permits increased, unemployment was subdued, and PMI data remains expansionary.

Between the FRB keeping short rates high and international demand for yield keeping long rates low, the yield curve is not the indicator it once was. It should not be ignored, however there are enough extenuating circumstance to remain skeptical of its effectiveness.

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