What does an inverted yield curve mean?

If you don’t know what I’m talking about, here is a brief introduction. When you lend out money, do you want to be paid with a higher interest or not if you lend it out for a longer period time? Sounds too stupid to even ask, right? Of course everyone wants to get paid more if the lending period is longer as the risk is higher. So normally this should be the case for the government bond yields,  like the Treasure yields, e.g. the 10 year Treasure yield should be higher than the 2 year note. A yield curve that has been closely watched by the whole financial world is typically the yield spread (difference) between the 10 year vs 2 year Treasure yields. As we just said, typically you would see a positive difference with the 10 year higher than the 2 year. But from time to time, some strange things do happen (actually not so stupid) that the 2 year yield is higher than the 10 yield, causing a negative spread and therefore being called as inverted curve. So what’s a big deal about the inverted curve if happening? Well, in the past 6 decades since such tracking available data, each recession (I think more than 5 times to date) has always been preceded by an inverted yield curve. In other words, the yield curve has become a very accurate predictor for the possibility of the next recession. It makes sense if you think about it fundamentally. Banks are basically making money by borrowing the short-term money with a lower interest to pay and then lending out the money with a higher interest to earn. If the yield curve inverted, banks will lose money by doing so and they will cut back on this major business. When the banks don’t lend money, the whole economy will suffer with less liquidity, eventually leading to a recession. In the past 10 years since the last recession in 2008/2009, the yield has been widely positive with the difference is comfortably above +1% all the times, even reaching +3% in 2011. But now, the yield curve is quickly flattening (narrow) and is below +0.3% as I’m writing. It is still positive and therefore I have been saying for a couple of months that I’m still bullish for this year at least and I don’t think a recession is an imminent threat, thanks to Trump’s pro-business policies. Actually more than two years ago I was even talking about a recession coming soon as at that time it was a real possibility the anti-business policies from the last administration could continue (no one thought Trump could win, right?). Regardless which side you are lining up, you should thank Trump at least on this that he has significantly postponed the next recession to come.👊👊

 

But the yield curve trend is indeed very worrisome as of now and I think it is a very high likelihood that it may invert in the next 6 months or so. History indicates that when a yield curve inversion occurs, it can take about 6 months to 2 years to lead to a recession to come. Here is my prediction how long the recession will come after the inversion based on different scenarios below. And I think it may very well be tied to the political landscape in the US. Roughly I think we may see three cases as follows:

• The mid-term election allows the GOP to maintain its control for both the Senate and the House and even better, Trump can win in the next election at 2020 for another 4 years with GOP to control both as now. This should be the best case scenario from the economic perspective and the next recession may be substantially delayed, by probably 2 years or even longer after the inversion.
• On the opposite side, if GOP loses control for both at the mid-term election that will cause Trump a great deal of challenges to continue to push for his pro-business agenda or if GOP loses the next presidency with DEM to control both as well, we probably will see a recession soon and last much longer than usual with more severity.
• Then the last scenario is anything in between.

 

Of course, economy is an extremely complicated phenomenon to predict and many other factors will also impact on it substantially. But personally I think the political landscape has a great weight to influence its direction. After all, the current economic momentum is supper strong with many records being broken already. While ironically a strong economy will inevitably lead to higher inflation that may cause a recession down the road, I believe the strong and free economy should do much more good than bad in the long run. I continue to hold the view that a huge financial crisis is coming in the years ahead due to decades long of unprecedented liquidity bubble created not only in the US but globally without solid economy to support. I only wish the current strong US economy can continue uninterrupted that can buy more time to at least lessen the severity of the inevitable financial crisis that is coming!   

 

You may think I’m talking about politics here since apparently I’m more in favor of the current economic policies. Not at all, folks! Let me give a bit historical lesson why it is so important to let the current booming business landscape uninterrupted to delay a recession. As I have said, the next crisis will be the debt crisis in a scale we have never seen before. The last recession in 2008/2009 was triggered by the housing bubble that led to a widespread bankruptcy of debt-burdened companies, which caused a full blown financial crisis at the end.  Just prior to the blowup of the crisis in 2007, it was reported that about 6% of the largest US companies could not cover the interest payments on their debts by their earnings. Today, a study done by Bianco Research suggests that as high as 15% such companies cannot earn enough to pay their debt interests, almost 3 times more than 10 years ago. Based on a simple logic thinking, can you tell me which scenario above is more likely to postpone the time bomb to explode? I’m just talking pragmatically!

 

As I said, I’m usually early in forward looking and there is no immediate concern on a recession as of now. But I think you will start to hear a lot more discussions about the yield curve inversion that is fast flattening. Hope this will help you to understand more what it really means for our money in the market. After all, the US mid-term election is just a few months away and it may have more profound impact on the economic prospect than you may think. At least this is how I’m looking at it!