Debating the inverted yield curve

30Dec05

Frankly we are already weary of the “debate” over the inverted yield curve. Perhaps the slow, holiday news week that has amplified the volume on the debate. The debate, as always, is being waged by participants eager to use this event as a justification for their own views. Bears on the economy view this as support for their position, and bulls are forced to downplay the significance of the inverted yield curve. So a few points:

  1. Inverted yield curves are relatively rare events.
  2. Flatter yield curves have been historically associated with lower economic growth.
  3. Things may or may not be different this time.

Forecasting the economy (and the stock market) is a crapshoot at best. However an inverted yield curve is one clue that in the past has indicated slower growth ahead. Not an guaranteed recession, not a stock market crash, but slower than average growth. Everybody should take a deep breath and relax.

If you were bearish on the economy and the stock market for next year this gives you another arrow in your quiver. If you were bullish, then take a moment to re-examine your assumptions. Investors would be better served to think about what an inverted yield curve means for certain sectors.

Justin Lahart in the Wall Street Journal makes a more subtle point in regards to the yield curve. While the effect on the general economy remains to be seen, a flatter yield curve could very well put pressure on the financial economy.

The mainstay of the banking business is borrowing money at low, short-term rates, lending it out at higher, long-term rates, and pocketing the difference. A variation that many financial institutions (including Wall Street firms) engage in are “carry trades,” which use short-term debt to fund riskier, long-term investments. When the yield curve inverts, many of these profit-making opportunities go away.

Caroline Baum at Bloomberg.com has a column in a vein similar to this one. Some of the rhetoric in regards to this event probably arises out of a misunderstanding of the statistics involved.

While it’s true that inversions have an excellent track record of forecasting recessions — there’s a reason the spread is one of 10 components in the Index of Leading Economic Indicators — it doesn’t mean the shape of the curve should be ignored until the long rate dips below the short rate. The curve emits signals, albeit not recessionary ones, along the way from steep to flat to inverted.

“There is a persistent predictive relationship between term spreads and future real output, though the precise parameters may change over time,” Estrella says in a series of frequently asked questions (and answers) posted on the New York Fed’s Web site.

In summary, no indicator is perfect. The economy is going to do what the economy does. Investors would probably be better served to look at the effect a sustained, inverted yield curve would have on particular sectors in the economy. Trying to forecast GDP to the correct decimal point in the long run isn’t going to be a good use of your time, or frankly anyone’s time.




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