an inverting yield curve: what it means

The primary economic goal of the US is to achieve maximum non-inflationary GDP growth. The government sets a general framework for this through fiscal policy–taxation and government spending. And, in theory as least, it stands at the ready to deal with shocks to the system. Monetary policy, in contrast, is a more flexible–and faster-acting–tool. It attempts to guide the economy through the business cycle by raising rates when the economy is running to hot and lowering them when the cooldown begins to take effect. The main rate it acts on is the Fed Funds rate, the price of overnight borrowing between the Fed and the big money center banks.

For government debt, where credit quality is presumably not an issue, the key determinant of the interest rate of a debt security is its term–the length of time before the principal most be repaid. A normal yield curve is what one would expect: the longer the term, the higher the interest rate.

When it sees the economy is growing too fast, the Fed begins to raise the Fed Funds rate to slow things down. At first, the entire yield curve shifts upward. At some point, however, holders of longer-term (say, 10-year) Treasuries make the judgment that their yields are high enough that they can ignore business cycle-related fluctuations in the price of overnight money that they think are only temporary.

If/as the Fed Funds rate continues to rise, the yield curve inverts–meaning that the yield on shorter-term securities is higher than that on longer-term ones.

Securities markets traditionally take yield curve inversion as an indicator that the Fed has gone too far in reining in near-term economic growth and that it will be unable to reverse stance fast enough to avoid at least a mild recession.

Maybe this will be the case again today, as the Treasury yield curve flirts with inversion. There are several unusual factors, though, that make the conclusion less than clear:

–although the Fed is already raising short-term rates, it continues to suppress longer-term yields by its bond buying, thereby gabling the yield curve message

–unusually, the bulk of government stimulus in this expansion is coming from fiscal spending, which has been generally absent in prior expansions. Arguably, Fed policy should be more restrictive than usual to offset this.

–longer-term Treasuries are as safe haven asset. In the first decade of this century, for example, Chinese buying pushed the 10-year yield as much as a percent lower than they would have been from domestic buying alone. Today, the war in Ukraine and the consequent weakness in the yen and euro may have caused international bond managers to shift holdings to Treasuries.

On the other hand, there’s:

–supply chain disruptions are being made worse by covid-induced slowdowns in China

–the war has reduced output from Russia and Ukraine, from wheat to minerals to coders

–the surprisingly large (to me, anyway) support for the Russian invasion from the domestic political right. There’s also the growing evidence that January 6th was not a spontaneous act, but the result of deliberate action by elected officials. Not a confidence booster for international investors.

My bottom line: it’s too early to tell whether inversion is really happening and whether it will have its usual predictive power. Something to keep an eye on, though.

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