An inverted yield curve is almost guaranteed to spook investors. To some it’s the ultimate forecast of doom and gloom in the economy. When it momentarily went inverted recently, markets swooned until the Federal Reserved made comforting little noises about potential rate reductions.
Nevertheless, while an inverted yield curve generates lots of chatter in the press, it’s not the infallible signal it’s reputed to be.
Normally we would expect that investors would receive higher yields for taking longer duration bonds. After all, there is a risk to longer durations and investors want to be compensated for it. So, if we plot yields against time, we would see that yields rise. That only makes sense. Unless you get a higher yield why would anyone take additional duration risk? The invisible hand prices bonds accordingly. The yield curve slopes upwards.
But, occasionally for any number of reasons short term bonds suddenly have higher yields than longer bonds. The yield curve slopes downward. In other words, it’s inverted.
Many investors believe that there is some magical information incorporated in an inverted yield curve that forecasts recessions about two years out in the future. In theory this signals that the economy will soften in the future and profits will decline causing investors to sell stocks and buy the relatively safer bonds. As they do this, supply and demand would drive up the prices of bonds which in turn decreases yields. There is some truth to this but other important factors come into play.
The bond market isn’t perfect. Central banks can and do whatever they care to to short term rates and the money supply. Because of their massive presence it’s fair to say they are the market. They employ monetary policy to promote full employment and limit inflation. And monetary policy is market manipulation. They set short term rates and adjust money supply.
If the Federal Reserve or other central banks believe the economy is overheating with a threat of inflation building, they will raise short term rates to head that off. Generally they will telegraph their intention to engineer a “soft landing” and slow the economic expansion. The investor fear is that the Fed will overreact and raise rates too early and/or too much thus triggering a recession. In turn this promotes a herd mentality that further moves markets.
Longer term rates are much more market driven. However, even here central banks can massively intervene to influence interest rates or manipulate their currencies.
Bond rates and yield curves are subject to all kinds of manipulations.
The dollar is the world’s reserve currency. Foreign investors may seek currency, political, economic stability, or a place to park their trade surpluses. For instance, the Chinese have long been suspected of buying dollars to artificially lower their currency. As foreigners and other institutions buy US bonds they push the price up, and the yields down.
There has been some correlation between inverted yield curve and future economic softening. But, in 1995 and 1998 after the yield curve became inverted the Federal Reserve cut short term rates to restore an upward slope. There was no recession. The signal is far from perfect.
Before you panic over the latest inverted yield curve story, keep in mind the Fed can lower interest rates any time they feel like it to restore a rising yield curve, and that even telegraphing that they might do so in the future can impact global markets. The Fed is very aware that a prolonged inverted yield curve won’t be interpreted as a healthy sign. They can drop rates almost instantly whenever the spirit moves them. However, predicting what they might do or when is a loser’s game. The only people who really know aren’t talking.
Headline investing seldom pays off. As an investor, the best thing you can do next time you hear an inverted yield curve story is to ignore it and go play with your grandchildren.