The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

Yield Curve Over-Reaction


Think of buying a bond like loaning money to a friend.  If he must repay the money tomorrow, there is not much that can go wrong before then.  However, if he must repay you in twenty years, there are many things that could go wrong, and you might not get repaid.  An example would be a surge in inflation, reducing the value of the repaid dollars whenever the loan matures.  Obviously, the longer the maturity, the greater the risk, and you should be compensated for that risk with a higher interest return.

Normally, the interest rate on long-term bonds is higher than the interest rate on short-term bonds.  This is “the yield curve.”  Sometimes, the difference between those rates (called “the spread”) gets very small or actually inverted, which means short-term rates become higher than long-term rates.  Historically, this predicts a recession.

But not always!  The joke is that an inverted yield curve has accurately predicted 13 of the last 7 recessions.

An inverted yield curve would be more useful in a really free market.  Everybody knows the Fed controls short-term rates and the free market controls long-term rates.  However, since the global financial crisis in 2008/9, when the Fed began Quantitative Easing or buying bonds out of the market, the Fed has had more control over long-term rates.  While the Fed is working to reverse QE by selling long bonds, they have a long, long ways to go.  In other words, the Fed can fix an inverted yield curve, but that’s not necessary.

In the meantime, the only industry directly impacted by an inverted yield curve is the financial sector, which “borrows short and lends long.”  They pay interest to depositors based on short-term rates and lend money to borrowers, who pay long-term rates.  Banks make their profit on the difference, and their stocks have been hurt badly by the more narrow spread between the two rates.

The ugly day on Wall Street yesterday, where the Dow fell almost 800 points, was caused by an over-reaction to a possible recession, as predicted by the current yield curve.  But, Wall Street always over-reacts.  I think yesterday’s over-reaction reflects unusually high anxiety.  Wall Street doesn’t believe the Trump Trade Truce means anything, and it is frightened by declining growth in corporate profits.  Uncertainty about Fed Head Powell raising interest rates continues, despite his dovish comments last week.

There is a time to be worried about an inverted yield curve.  This is not that time!