What's meant by the Inverting Yield Curve?

Dear Trader

The blogosphere is full of the impending collapse of the Dow with some pundits talking of 14,000 in 2019, a modest 10,000 points lower. Right or wrong, the fuel that has kept stock markets forever bubbling, an endless wall of money and a strong economy, will eventually end. Is the yield curve telling us the economy is about to fall of a cliff?

Normality

Government and corporate bonds are issued with different maturities. The standard US bond is the 30 year, but there are many different maturities, typically 3, 5 and 10 year, etc. Some run for just a few months to maturity, whilst some whacky corporate bonds have been issued with maturities way out at 100 years!

As the economy ebbs and flows the yield, interest rate, on bonds moves up and down as the bond price also moves. Now, the interest rate on long term bonds is usually higher than that of the shorter dates.

This is how the banking system works. Banks borrow short term at lower rates, then lend out over longer periods at higher rates and pocket the difference. Understandably, banks and investors want a greater interest rate of return the longer the money is tied up.

A typical yield curve tracks the difference between the bonds maturities. This shows the curve increasing back in the, relatively, normal times of 2005:

When the economy is expecting a recession, Central Banks reduce expectations of rate rises. Interest rates fall, starting at the longer maturities, and when the Yield curve turns negative, or inverts,  a recession often follows along.

This is what preceded the 2007/8 stock market tumble:

The curve went upside down. Short term rates were higher than long term and down the economy tumbled with the banking sector's shenanigans. When the curve inverts, the usual banking cycle of borrow short lend long, goes into reverse and with it, their profits.

Right now, the curve has gone flat with the 3-5 year inverting:

That's why the talking heads and pundits are predicting a recession is on the way and interest rate rises are most likely to stop or even fall.

This year next year when?

Looking back to 2007, the inversion started early in 2006 which gave a lead time of 18 months+ before recession hit. As we've seen, the US Federal Reserve has been increasing rates and is still expected to do so one more time this year on 19th December.

Powell, the Fed Chairman, at his last statement suggested that US rates were 'just below the neutral rate'. Taking that to mean the neutral rate for the economy is 1/4% higher than the current 2.25% gives us the last rate increase this year.

Most likely that's it, nothing more - no more rises in 2019 as the yield curve inversion signals recession by 2020.

And the markets?

Stock markets have loved QE, stock buy backs and tax cuts. The effects of all these are likely to dissipate through 2019. QE is tapering down. The error of stock buybacks, using debt as growth falters, is hammering the likes of General Electric and General Motors, etc., and the tax cuts feel good factor can't happen every year.

These are all headwinds, but if the market does take fright from an impending recession will the Fed step in again and chop rates back to zero in an attempt to save the stock market? They've got form on this and are unlikely to allow the market to tank when it’s in almost everyone’s interest to keep it bubbling.

The Dollar

Right now it's looking as though it has more upside as rising rates have created a worldwide dollar shortage. That shortage has been squeezing emerging economies as they struggle to pay rising rates on their massive dollar loans.

If the dollar has no more momentum after what could be it's last rate rise on 19th December, then look for an end year top and load up on the Euro for 2019. Assuming Italian debt doesn't default!

Gold and Silver

If the US Dollar does peak, Gold will get a shove upwards as the Dollar falls. The next newsletter will look at how the two interact now the Gold/Silver ratio has reached an all time high.