Inverted Yield Curve Implies Recession Coming

     The yield curve has become inverted for the spread between the 2 year and 5 year Treasury. The entire yield curve has shifted to be close to being inverted. Traditionally it takes a long time, perhaps 1.75 years after yield curve inversion before a recession starts. However, since the 2008 GFC the extreme manipulation by central banks, such as the QE program, that have never before been experienced, means that things will not act as they typically do during a yield curve inversion. Assuming the short end of the yield curve (for maturities under two years) is heavily manipulated by central banks and less so the further out one goes from short term maturities, then the traditional metric that it takes a long time for the inversion to lead to recession is no longer applicable.
The world has become doubly indebted as a ratio of debt/GDP doubled since 1996, thus the effect of changes in interest rates should at least be twice as powerful as in the past. Also in the past 20 years there has been much more opportunity for junk quality borrowers to get financing from naïve shadow bank type of lenders. These weak borrowers are much more susceptible to a sudden upward movement in rates. And the new crop of shadow bank lenders (peer to peer, or BDC, etc.) are much more likely to quickly fold like a house of cards and cut off funding to this class of borrowers once they see a rise in defaults.
Ben Bernanke said QE made rates 0.85% lower than they otherwise would have been; other experts claim the effect of QE was a change factor of 0.5%. Assuming this mainly effects the short term and intermediate term debts then that could be quite a problem for weak borrowers including future prospective buyers who won’t be able to buy things on credit, thus leading to a recession. As a result of changes in the nature of debt over the past 22 years I think the effect of an inverted yield curve could occur much more rapidly than the old paradigm of 1.75 years.

     The ridiculous debt bubble of the EU and Japan where yields are below zero in some cases and the central banks bought stocks to devalue their currency is such a bizarre situation that surely it is a fragile, brittle house of cards ready to collapse rapidly, if triggered by a modest disturbance. Thus the symptom of a trend of or a near inversion of the yield curve has a much greater risk of promptly morphing into recession instead of taking its sweet time to slowly have loan defaults increase until credit is shut off. A yield curve inversion can be both a symptom of an economy going into recession and also a cause. If it is a cause of recession that would be because an inversion makes short term rates unaffordable, resulting in would be borrowers refusing to buy things on credit. Also short term debt such as margin loans is used to buy stocks by some investors. When short term debt is too expensive then people sell off their leveraged holdings of stocks and pay down the margin loans, resulting a shrinking of the money supply. Instead of “cash on the sidelines” it becomes sort of a metaphor of “negative money on the sidelines” that vacuums up spare cash and thus reduces purchasing power, leading to recession.
Investors need independent financial advice about the yield curve inversion leads to recession and stock crashes. Typically junk bonds crash a half year before stocks crash, which in turn crash six months before the economy goes into recession. Thus if a recession starts 1.75 years from now then stocks would crash 1.25 years from now, except that this an old paradigm; the new paradigm is that QE has built a huge shaky house of cards that can fall faster than people’s expectations.
Stocks have been in a big bubble for several years. To navigate (or imagine they are going to navigate) the bubble investors have recklessly abandoned fundamental analysis of stocks and instead use technical analysis of looking at patterns on a chart. But this is very risky since chart trading is considered by finance professors and economists to be unscientific and unreliable. Thus technical traders have no choice but to ruthlessly sell at the drop of a hat whenever a scary statistic like yield curve inversion occurs. Thus they won’t meekly wait around 1.75 years after yield curve inversion before a stock crash but instead will liquidate assts at a heartbeat. Thus expect stock crashes to happen much faster than under the old paradigm.
The stunning crash of the Dow Transports today, a drop of 4%, is a wake up call that recession is coming.

2018-12-07T14:11:31+00:00December 7th, 2018|mayflowercapital blog|Comments Off on Inverted Yield Curve Implies Recession Coming

About the Author:

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Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years. Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services. Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.