Widely anticipated by some, it’s at once feared, dismissed, worshipped and condemned in the multipolar world of money management. But no matter your view on the advent of the inverted yield curve, it’s here (or, at least it was), and has spawned fresh debate about what awaits in 2006.
But for all the deliberation on what it does or doesn’t mean, there are but two basic paths of reaction to an inverted yield curve. One, ignore the event, which paid an ignominious visit yesterday to the Treasury market for the first time in five years. Or, for those with darker inclinations, there is the traditional conclusion, namely, that a recession will soon follow.
There is no shortage of support for taking the latter route. Exactly how we get from here to there is the prevailing conundrum. By most statistical measures, the economy is humming along, and so immediate and obvious signs of slowdown are hard to come by. Scarce, perhaps, but not beyond the pale, to judge by the various warnings of what might go wrong. In any case, pessimists the world over recite the history of economic slowdowns that have followed the inversion of yield curves, a sorry state of fixed-income affairs where short rates exceed long. A recent statistical summary of the bad news can be found in a recent New York Fed appraisal of yield curves and their role as a leading indicator. Among the observations: since 1960, yield-curve inversions have preceded every recession in the United States. (How’s that for cutting to the chase?)
As to why one should lead to the other, Paul Francis Cwik took a crack at an answer in his 2004 Ph.D. dissertation, for which research support was provided by the Ludwig von Mises Institute. “As money is injected into the economy, the yield curve steepens,” Cwik writes. “The steepening yield curve creates incentives for entrepreneurs to create short-term malinvestments throughout the structure of production, and it misleads entrepreneurs so that they do not terminate long-term malinvestments. These long- and short-term malinvestments accumulate in every part of the economy. When the level of disequilibrium becomes so great, the economy reaches the upper-turning point and heads toward a recession.”
To wit, Are you malinvested?
Whether that line of inquiry is informed or not, the stock market seems to have jumped on this pessimistic bandwagon of late. The S&P 500 took a 1% tumble yesterday, presumably in sympathy with the notion that the arrival of an inverted yield curve yesterday, if only briefly, heralds something less than robust economic growth. If nothing else, yesterday’s selloff in equities adds fuel to the notion that the 1275 range for the S&P is the new ceiling for the market.
But if recession is coming, why is the Federal Reserve still raising interest rates? For some, the answer is simply, it’s not, or at least it’s close to ending the squeeze play. The inverted yield curve “suggests we are very close to the end of the tightening cycle,” Michael Rottmann, strategist at Hypovereinsbank, tells Reuters. What’s more, he doesn’t think the inversion signals the onset of recession. Rottmanns’ expectations, we can say with absolute authority, represents the bullish ideal for the various scenarios that inhabit the prognostication business of late.
In fact, the March 2006 Fed funds futures is priced in agreement as it relates to Rottmann’s outlook for rates, with the contract projecting a rate of 4.5%, or 25 basis points above the current level.
A topping out of rate hikes has obvious appeal, but the implications for the dollar aren’t among them. The U.S. Dollar Index suddenly looks tired in the wake of all the inversion talk. Without the allure of elevating yields in the buck to stir the forex pot, the dollar may wilt further if the trade balance continues to deteriorate.
But lest we go too far off the deep end, yesterday’s dalliance with an inverted yield curve has yet to prove itself durable. The two- and 10-year Treasuries each sported a current yield of 4.36% in this morning’s trading, according to Bloomberg. If the inversion has legs in the days and weeks ahead, all eyes will be on corporate earnings and the various economic reports for clues about what comes next. The housing market arguably leads the top of the list as the leading catalyst that could turn the sunny economy cloudy.
There is no clarity in the marketplace of the 21st century. In its stead are multiple scenarios and an ever lengthening list of risk factors to embrace or dismiss. So many variables, so little time.