The Inverted Yield Curve With An Asterisk

In 2006, Capital Advisers (correctly) wrote that “Compared to past periods, the yield curve inversion we are experiencing is quite benign, so there need not be profound concerns that an economic recession will automatically derive from this phenomenon”. It wasn’t a hunch that made Capital Advisers write this, it was historical Facts, Math & Data:

“The yield curve inverted (negative 2yr & 10yr yield differential) eight times, for at least one month at a time, in the last 30 years…

The average duration of an inversion was seven months…

The average negative spread was 0.33% (33 bps)…

Dispersion of severity exist, for example, a mild one started June 1998 with an inversion lasting one month of 3 bps; and an inversion beginning Aug 1978 lasting 21 months getting to as much as 202 bps.

Conclusion: Not all inversions lead to recessions, there is ONLY a correlation between severe inversions leading to recessions.

Furthermore, not all recessions were preceded by inversions—between 1954 and 1966 there were three recessions but no inversions.”—Capital Advisers, 03/01/2006

One other point that should also ease concerns about any near-future yield-curve inversion is that if it does happen, this would be the inverted yield curve with an asterisk because this would be the first time that there was a yield curve inversion while the Fed was sitting on $4.2T of long-term bonds ($2.4T in Treasury bonds and $1.8T in mortgage-backed bonds) on its balance sheet (that it removed from the bond market).

Meaning that if the yield curve inverts, it has an asterisk because of Bonds (Treasury & MBS Bonds), similar to that baseball that has an asterisk because of Bonds (Barry Bonds).

Remember, the whole point of the Large Scale Asset Purchases (so-called ‘QE’) was to drive long-term bond yields lower. So while nobody knows where long-term bond yields *should* be right now, we can all safely assume that long-term bond yields would be higher right now if the Fed never bought those long-term bonds (if the Fed wasn’t still engorged with those bonds).

Which is why Fed Chair Powell isn’t too concerned if this yield curve (with that asterisk) inverts.

Of the $2.4T of the SOMA (the Fed balance sheet) Treasury bond holdings, approximately 92% have a 10-year maturity or more.

By merely hinting that the Fed was even considering selling some of those an intra-meeting move (‘dumping’ them back on the ‘street’ into the bond market), that yield curve inversion is gone in 15 nanoseconds.

 

Thanks for reading,

 

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