There has been and will be a lot of talk about the yield curve and the term inversion.
Investopedia defines an Inverted Yield Curve as “an interest rate environment in which long-term debt instruments have a lower yield than short term debt instruments of the same credit quality.”
There can also be a partial inverted yield curve which is when the short term yield (debt of 5 years or less) is higher than the long term yield (typically the 30 year bond) but the intermediate yield (10 to 15 year debt) is at appropriate levels.
When an inverted yield curve is discussed by the talking heads on TV it is often followed with the comment that it is a predictor of a recession. But they never explain why.
Here is the concern. When the yield curve inverts it is harder for banks to lend money at a profit. The spread between long term rates and short term rates (which means the difference in interest rates) is negative. When banks can’t lend money for a profit they stop lending money. When corporations or individuals can’t get loans from the bank they stop spending. When spending slows down we have the beginnings of a recession.
For the inverted yield curve to impact the economy it must be sustained for a reasonably long period of time. So as of right now, we don’t know if the inverted yield curve is actually a predictor of the next recession. There is a second concern. What is the emotional or psychological impact of even a temporary inverted yield curve?
Investors sometime react without fully evaluating the economic situation or having all the information to understand what is going on in the markets.
How did we get here? Many in the investment community believe that the tightening or raising of interest rates by the Federal Reserve caused the inversion to happen. Because the Federal Reserve can only raise or lower short-term interest rates.
So when you hear the President pushing the Federal Reserve to move interest rates lower, part but not all of the reason is because we are seeing an inverted yield curve.
What should we do?
This is definitely a red flag. It will be important to monitor financial firms and corporate borrowing over the coming months to see how much of an impact this will have on economic activity.
I will keep you updated as we gather more information over the coming weeks and months.
My best, Mark