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Explaining Yield Curve Inversions

The Yield Curve briefly inverted -- twice -- Monday. As we noted yesterday, the deeper and longer a curve remains inverted, the more potentially significant it is.

That factoid has been overlooked by many commentators. Following yesterday's post about what an inversion means, it became apparent that there is alot of confusion about the implications. So far, all we have is a brief inversion -- which, for the moment, is merely a warning.

The best explanation I've read for what the Inverted Yield Curve may mean to the economy and markets comes from Lacy Hunt, a veteran Wall Street economist who formerly worked at the Dallas Fed:

"There has been a lot written about the flattening yield curve, though most people don't understand what causes it.

The narrowing spread between yields is a superb leading indicator but shouldn't be observed in a vacuum -- no lone silver bullet can take down the economy. A steep flattening of the yield curve is a sign that the Fed is in the later stages of tightening its monetary-policy belt. It's part of the broader process. But once it occurs, it does have its own implications for the economy and the markets.

Treasury yields should be viewed in concert with central-bank policy and changes in the availability of money and credit. The Fed influences supply and demand for money when it raises the fed-funds rate, since it pushes up money-market yields. To boost the funds rate, the Fed has to cut down on total reserves -- money that banks are required to keep around for backing up deposits.

That reduces how much money can be supplied to people and businesses for borrowing and investing and it crunches the availability of credit that Americans now rely heavily on to keep up their spending habits. Banks' profits, meanwhile, are crimped because they can't make easy money by borrowing at low, shorter-term rates and lending at high, longer-term rates -- one version of the time-honored carry trade. Higher rates can grind the borrowing and lending process to a halt -- or it can reverse, where people pay their loans with money they normally would spend elsewhere. All told, economic growth is stunted.

The yield curve is flattening because Fed policy is working -- it's not a surprise that a higher fed-funds rate is followed by slowing growth in money supply and a narrowing in the spread between short- and long-term Treasury yields. This is clearly evident as 2005 draws to a close: Total reserves fell 4.1% in the past 12 months, and the contraction has happened at a faster pace in recent months because of the cumulative impact of 13 Fed rate increases. M2 money supply -- cash, deposits and short-term assets such money-market funds -- increased a paltry 3.4% in the last 12 months, the slowest growth in 10 years.

While the flattening yield curve is part of the process, it shouldn't be taken lightly. This barometer narrowed significantly prior to all of the recessions since 1954, as well as two major business slowdowns in 1967 and 1995. In the middle of those slowdowns, the economy grew at annual rates of 1.6% and 0.9%, respectively. Only quick and decisive Fed action prevented worse conditions. Since 1954, growth in M2 when adjusted for inflation slowed dramatically in the four quarters right before recession. The same thing happened with the slowdowns of 1966 and 1995. That is why both the yield curve and M2 supply are widely considered excellent leading indicators.

Growth of less than 1% in real M2 in the past four quarters, combined with a sharp contraction in total bank reserves, reinforces what the yield curve is telling us: The economy is headed for a slowdown. That means either less inflation, less real growth, or some combination of the two."

I hope that's not too wonky; it is as clear an explanation I've ever read, without dumbing it down too much. Note that the past 4 recessions were preceded by a Yield Curve Inversion, and prior flattenings have predicted a slowdown.

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Here's a chart from today's WSJ:
click for larger graphic

chart courtesy of WSJ

UPDATE:   December 31, 2005  5:13am

A reader asked for a study on inversions and recessions. Marketwatch reported that Merrill Lynch just released a study (on Friday!) on the subject: 

"The historical record speaks for itself," said Merrill Lynch analysts in a report published Friday.

"In the past 30 years, the yield curve has inverted five out of the eight times the Fed has been tightening monetary policy. Each of those five times an economic recession has ensued one year later -- our fear (though not our base case) is that this time will be no different."

If anyone has access to this, please contact me about  sending it.

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Sources:
Examining an Inversion
TRADING SHOTS
WSJ, December 23, 2005
http://online.wsj.com/article/SB113528182051629707.html

Yields on Bonds Invert, Reflecting Unease About Economy's Future
MARK WHITEHOUSE
THE WALL STREET JOURNAL, December 28, 2005; Page A1
http://online.wsj.com/article/SB113569973698732182.html

Stocks could see rebound on data
Economic data and 4Q earnings to greet the New Year
Jasmina Kelemen
MarketWatch, 5:01 AM ET Dec. 31, 2005
http://tinyurl.com/849qk

Wednesday, December 28, 2005 | 06:30 AM | Permalink | Comments (17) | TrackBack (3)
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Comments

I simply don't understand why the Fed is so retarded. Boom/bust/boom/bust. When they have a 100% record of causing a wreck, why don't they just try stopping a little earlier? Has anyone ever tried biting off smaller chunks with the objective of long term price stability.

I believe in some powers the Fed has and not some of the other. The markets should set rates on the short end. They are much more efficient than a handful of bureaucrats causing a constant yo-yo.

Some economists argue the Fed causes inflation. May sound humerous but think about it.

Posted by: B | Dec 28, 2005 9:09:07 AM