The Flattened / 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

Fast forward to 2018, one other point that should also ease concerns about this flattening yield curve (or any possible yield-curve inversion in the near future), is that this yield curve had an asterisk—because this was a yield curve while the Fed was sitting on $4.2T of bonds ($2.4T in Treasury bonds and $1.8T in mortgage-backed bonds) on its balance sheet. Removing those long-term securities from the bond market gave today’s yield curve a flattening ‘advantage’ over other yield curves of the past, so any comparison would be ‘unfair’.

Meaning that today’s flattening yield curve (and if it happens, an inverted curve), has an asterisk, because of bonds (Treasury Bonds); similar to that baseball that has an asterisk, because of bonds (Barry Bonds).

The issuer of dollars (the federal gov’t) has complete monopoly power over dollars and it mandates its banking agent (the Fed) with monopoly power over the ‘price’, or interest rate, of dollars to maintain price stability throughout the economy. The purpose of the Large Scale Asset Purchases, so-called ‘QE’, begun by the Fed in November 2008, was to intentionally drive long-term bond yields lower (and the Fed also lowered the short-term target interest rate to ZERO percent the next month). So while nobody knows where long-term bond yields *should* be right now, we can all safely assume that long-term bond yields would today be higher right now if the Fed never bought and was not still engorged with all those long-term bonds.

Which is why Fed Chair Powell probably isn’t too concerned that this yield curve, with that asterisk, is flattening.

In addition, the reason why Fed Chair Powell probably isn’t losing too much sleep over the thought of a possible yield curve inversion is this:

Of the $2.4T of the SOMA (Fed balance sheet) Treasury bond holdings (one of two bullets in its double-barreled bazooka), approximately 92% have a 10-year maturity or more. By merely hinting that the Fed was even considering an intra-meeting move and selling those long-term securities back to the secondary bond market (‘dumping’ them on the ‘street’), that yield curve flattening / inversion is gone in 15 nanoseconds.

 

Thanks for reading,

 

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